Revisiting Asset Pricing Anomalies in an Exchange Economy

Abstract

Several well-known asset pricing anomalies arise when simple endowment economies are calibrated to real data. We show that many of these anomalies are largely mitigated, and even disappear, if we endow the representative agent with an arbitrarily small minimum consumption level. We illustrate this point in a standard one-tree Lucas exchange economy with power utility and lognormal consumption growth. Insuring the agent's consumption allows us to solve the model for parameter values where the standard model is not defined. For such parameter values, disasters are much more important for the representative investor, and the equity premium therefore higher, even though the insurance makes consumption less risky. Our model yields reasonable risk premia, Sharpe ratios and discount rates; excess price volatility; a high market price-dividend ratio; and an upward-sloping term structure. Technically, our model leads to nonlinear price functions and to price dynamics quite different from those in the standard model. The model is tractable, and we derive closed-form solutions for all variables of interest. We also establish that the results can be generalized.