The effects of moral hazard on asset prices when financial markets are complete

This paper discusses the implications for prices and quantities of an alternative trading arrangement in Kahn's (1990) economic environment with moral hazard. Unlike Kahn's model of asset trade, my model does not impose any unmotivated restrictions on short sales. Instead, it features complete markets and publicly observable asset transactions. Like Kahn's model, my model implies that allocations are (constrained) Pareto optimal. However, the implications of my model for asset prices are considerably different. In particular, when all agents have log utility, asset prices satisfy an aggregation theorem; also, unlike Kahn's model, the model in this paper does worse than the standard representative agent model in terms of explaining the equity premium. (C) 1998 Elsevier Science B.V. All rights reserved.