Three essays on heterogeneity, insurance, and asset pricing

Date of Completion

January 2007

Keywords

Economics, Finance

Degree

Ph.D.

Abstract

The first essay is on "Asset Pricing with Heterogeneous Agents, Incomplete Markets and Trading Constraints." The consumption capital asset pricing model is the standard economic model used to capture stock market behavior. However, empirical tests have pointed out to its inability to account quantitatively for the high average rate of return and volatility of stocks over time for plausible parameter values. Recent research has suggested that the consumption of stockholders is more strongly correlated with the performance of the stock market than the consumption of non-stockholders. We model two types of agents, non-stockholders with standard preferences and stockholders with preferences that incorporate elements of the prospect theory. Each agent faces idiosyncratic shocks to his labor income as well as aggregate shocks to the per-share dividend but markets are incomplete and agents cannot hedge consumption risks completely. In addition, consumers face both borrowing and short-sale constraints. Our model is able to generate a time-varying risk premium of about 5.5% while maintaining a low risk free rate, thus suggesting a plausible explanation for the equity premium puzzle.^ The purpose of the second essay; "Is There Propitious Selection in Insurance Markets?", is to explore the possibility that plausible but non-standard features of insurance demand can prevent the development of an adverse selection death spiral in insurance markets. While maintaining the standard assumption of asymmetric information; we explore the possibility of a pooling equilibrium in insurance markets in the presence of a negative correlation between riskiness and risk aversion which is known as "propitious selection". The novel feature of the model is that it allows for agent heterogeneity in both the coefficient of risk aversion and the probability of loss as well as for negative correlation between the two. Our results show that propitious selection cannot prevent market unraveling in the presence of asymmetric information.^ The third essay is entitled "Random Errors, Behavioral Biases and Market Equilibrium in Insurance Markets". One aspect of the problem of insurance demand that is largely ignored in standard insurance models is the cognitive requirements that insurance purchase imposes on insureds. In economic theory the probability of an accident is usually considered a "primitive" that is "known" by the insured. In reality, each individual should best be seen as trying to estimate his own probability of loss when making insurance decisions. Random factors may lead to noisy estimates of one's own probability of loss while bounded rationality may lead to biased estimates. We explore the implications of behavioral biases and random errors in the individual's estimation of his riskiness on insurance demand and market equilibrium in the presence of asymmetric and incomplete information. We find that when insureds have moderate uncertainty about their own riskiness equilibrium is possible, albeit with considerable selection. Allowing for behavioral biases strengthens our results.^

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