[We introduce limited liability in a model with a continuum of ex ante identical agents who face aggregate and idiosyncratic income risk. These agents can trade a complete menu of contingent claims, but they cannot commit to honor their promises, and their shares in a Lucas tree serve as collateral to back up their state-contingent promises. The limited-liability option gives rise to a second risk factor, in addition to aggregate consumption growth risk.This liquidity risk is created by binding solvency constraints, and it is measured by the growth rate of one moment of the wealth distribution. The economy is said to experience a negative liquidity shock when this growth rate is high and a large fraction of agents faces severely binding solvency constraints. The adjustment to the Breeden-Lucas stochastic discount factor induces substantial time variation in equity risk-premims that is consistent with the data at business cycle frequencies.]

We derive new estimates of total wealth, the returns on total wealth, and the wealth effect on consumption. We estimate the prices of aggregate risk from bond yields and stock returns using a no-arbitrage model. Using these risk prices, we compute total wealth as the price of a claim to aggregate consumption. We find that U.S. households have a surprising amount of total wealth, most of it human wealth. This wealth is much less risky than stock market wealth. Events in long-term bond markets, not stock markets, drive most total wealth fluctuations. The wealth effect on consumption is small and varies over time with real interest rates.

We assume that domestic (foreign) agents, when investing abroad, can only trade in the foreign (domestic) risk-free rates. In a preference-free environment, we derive the exchange rate volatility and risk premia in any such incomplete spanning model, as well as a measure of exchange rate cyclicality. We find that incomplete spanning lowers the volatility of exchange rate, increases the risk premia but only by creating exchange rate predictability, and does not affect the exchange rate cyclicality.

The consumption growth beta of an investment strategy that goes long in high interest rate currencies and short in low interest rate currencies is large and significant. Consumption risk price differs significantly from zero, even after accounting for the sampling uncertainty introduced by the estimation of the consumption betas. The constant in the regression of average returns on consumption betas is not significant. Additionally, this investment strategy's consumption and market betas increase during recessions and times of crisis, when risk prices are high, implying that the unconditional betas understate its riskiness. JEL: C58, E21, F31, G11, G12

Aggregate consumption growth risk explains why low interest rate currencies do not appreciate as much as the interest rate differential and why high interest rate currencies do not depreciate as much as the interest rate differential. Domestic investors earn negative excess returns on low interest rate currency portfolios and positive excess returns on high interest rate currency portfolios. Because high interest rate currencies depreciate on average when domestic consumption growth is low and low interest rate currencies appreciate under the same conditions, low interest rate currencies provide domestic investors with a hedge against domestic aggregate consumption growth risk.

We relate the risk characteristics of currencies to measures of physical, cultural, and institutional distance. Currencies of countries which are more distant from other countries are more exposed to systematic currency risk. This is due to a gravity effect in the factor structure of exchange rates: When a currency appreciates against a basket of other currencies, its bilateral exchange rate appreciates more against currencies of distant countries. As a result, currencies of peripheral countries are more exposed to systematic variation than currencies of central countries. Trade network centrality best predicts a currency’s average exposure to systematic risk.

We use a standard single-agent model to conduct a simple consumption growth accounting exercise.

[We use a standard single-agent model to conduct a simple consumption growth accounting exercise. Consumption growth is driven by news about current and expected future returns on the market portfolio. We impute the residual of consumption growth innovations that cannot be attributed to either news about financial asset returns or future labor income growth to news about expected future returns on human wealth, and we back out the implied human wealth and market return process. Innovations in current and future human wealth returns are negatively correlated with innovations in current and future financial asset returns, regardless of the elasticity of intertemporal substitution.]