We present a tractable general equilibrium model with multiple sectors in which firms offer workers incentive contracts and simultaneously raise capital in stock markets. Workers optimally invest in the stock market and at the same time hedge labour income risk. Firms rationally take agents' portfolio decisions into account. In equilibrium, the cost of capital of each sector is endogenous. The distortion induced by moral hazard generates counterintuitive effects on the real economy. For example, the value of labour market participation may be higher under moral hazard than under first best, further a positive productivity shock may decrease welfare in the moral hazard economy. In addition, our model generates predictions on the effects of moral hazard on asset markets. For example, in the presence of moral hazard, the capital asset pricing model fails because firms, by choosing optimal incentive contracts, transfer risk both through wages and through the stock market. This leads to several cross-sectional asset pricing “anomalies”, such as size and value effects. As we characterize optimal contracts, we can also present empirical predictions relating workers' compensation, firm productivity, firm size, and financial market abnormal returns.

[We show that several well-known asset pricing puzzles are largely mitigated if we endow the representative agent with an arbitrarily small minimum consumption level. This allows us to solve the model for parameter values where the standard "Lucas tree" model is not defined. For these parameters, disasters become more important, and the market risk premium therefore higher, even though consumption is less risky. Our model yields reasonable risk premia, Sharpe ratios, and discount rates; excess price volatility; and a high market price-dividend ratio. We derive closed-form solutions for all variables of interest.]

We show that several well-known asset pricing puzzles are largely mitigated if we endow the representative agent with an arbitrarily small minimum consumption level. This allows us to solve the model for parameter values where the standard “Lucas tree” model is not defined. For these parameters, disasters become more important, and the market risk premium therefore higher, even though consumption is less risky. Our model yields reasonable risk premia, Sharpe ratios, and discount rates; excess price volatility; and a high market price-dividend ratio. We derive closed-form solutions for all variables of interest.