The representative agent theory of asset pricing is modified to incorporate heterogeneous agents and incomplete markets. The model features two types of agents who differ up to a nontradable, idiosyncratic component in their endowment processes. Numerical solutions indicate that individuals are able to diversify a substantial portion of their idiosyncratic income risk through riskless borrowing and lending alone. Restrictions on the variability of intertemporal marginal rates of substitution are used to argue that incomplete markets, as modeled here, cannot account for the properties of asset returns that are anomalous from the perspective of representative agent theory.

ABSTRACT The representative agent theory of asset pricing is modified to incorporate heterogeneous agents and incomplete markets. The model features two types of agents who differ up to a nontradable, idiosyncratic component in their endowment processes. Numerical solutions indicate that individuals are able to diversify a substantial portion of their idiosyncratic income risk through riskless borrowing and lending alone. Restrictions on the variability of intertemporal marginal rates of substitution ( Hansen and Jagannathan (1991) ) are used to argue that incomplete markets, as modeled here, cannot account for the properties of asset returns that are anomalous from the perspective of representative agent theory.

An endowment economy with heterogeneous agents and incomplete asset markets is specified, parameterized and solved using a numerical solution algorithm. The model features two types of infinitely lived agents who are endowed with different sources for non-tradable income. Despite not being able to insure against endowment risk, individuals are able to partially diversify away idiosyncratic risk by trading in a limited set of competitive asset markets. Numerical results indicate that the model can account for substantially more of the variability in intertemporal marginal rates of substitution documented by Hensen and Jagannathan (1990) than can models based on a representative agent. In addition, the model can generate a mean risk-free rate of interest smaller than the rate of time preference and potentially account for the so called 'risk-free rate puzzle'.

Forward and spot exchange rates between major currencies imply large standard deviations of both predictable returns from currency speculation and of the equilibrium price measure (the intertemporal marginal rate of substitution). Representative agent theory with time-additive preferences cannot account for either of these properties. The authors show that the theory does considerably better along these dimensions when the representative agent's preferences exhibit habit persistence but that the theory fails to reproduce some of the other properties of the data–in particular, the strong autocorrelation of forward premiums.

How Important Are Idiosyncratic Shocks? Evidence from Labor Supply by Kjetil Storesletten, Chris I. Telmer and Amir Yaron. Published in volume 91, issue 2, pages 413-417 of American Economic Review, May 2001

Is individual labor income more risky in recessions? This is a difficult question to answer because existing panel data sets are so short. To address this problem, we develop a generalized method of moments estimator that conditions on the macroeconomic history that each member of the panel has experienced. Variation in the cross‐sectional variance between households with differing macroeconomic histories allows us to incorporate business cycle information dating back to 1930, even though our data do not begin until 1968. We implement this estimator using household‐level labor earnings data from the Panel Study of Income Dynamics. We estimate that idiosyncratic risk is (i) highly persistent, with an annual autocorrelation coefficient of 0.95, and (ii) strongly countercyclical, with a conditional standard deviation that increases by 75 percent (from 0.12 to 0.21) as the macroeconomy moves from peak to trough.

ABSTRACT One of the most puzzling features of currency prices is the forward premium anomaly : the tendency for high interest rate currencies to appreciate. We characterize the anomaly in the context of affine models of the term structure of interest rates. In affine models, the anomaly requires either that state variables have asymmetric effects on state prices in different currencies or that nominal interest rates take on negative values with positive probability. We find the quantitative properties of either alternative to have important shortcomings.

Forward and spot exchange rates between major currencies imply large standard deviations of both predictable returns from currency speculation and of the equilibrium price measure (the intertemporal marginal rate of substitution). Representative agent theory with time-additive preferences cannot account for either of these properties. We show that the theory does considerably better along these dimensions when the representative agent's preferences exhibit habit persistence, but that the theory fails to reproduce some of the other properties of the data—in particular, the strong autocorrelation of forward premiums.

ABSTRACT Forward and spot exchange rates between major currencies imply large standard deviations of both predictable returns from currency speculation and of the equilibrium price measure (the intertemporal marginal rate of substitution). Representative agent theory with time‐additive preferences cannot account for either of these properties. We show that the theory does considerably better along these dimensions when the representative agent's preferences exhibit habit persistence, but that the theory fails to reproduce some of the other properties of the data—in particular, the strong autocorrelation of forward premiums.

We study good-by-good deviations from the Law-of-One-Price (LOP) for over 1,800 retail goods and services between all European Union (EU) countries for the years 1975, 1980, 1985, and 1990. We find that for each of these years, after we control for differences in income and value-added tax (VAT) rates, there are roughly as many overpriced goods as there are underpriced goods between any two EU countries. We also find that good-by-good measures of cross-sectional price dispersion are negatively related to the tradeability of the good, and positively related to the share of non-traded inputs required to produce the good. We argue that these observations are consistent with a model in which retail goods are produced by combining a traded input with a non-traded input.