MORAL HAZARD, IMPERFECT RISK-SHARING, AND THE BEHAVIOR OF ASSET RETURNS

This paper develops a model of endogenous idiosyncratic risk in a simple two-period general equilibrium setting, and examines its implications for the behavior of asset returns. The model readily generates empirically plausible idiosyncratic risk in consumption and yields more realistic behavior of asset returns than comparable models with perfect insurance. The most dramatic effects of imperfect risk-sharing, however, are not on the spreads between asset returns but on their absolute levels. Overall the results suggest allowing for incomplete markets can contribute to a resolution of the equity premium puzzle. © 1990.