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General equilibrium with unhedgeable fundamentals and heterogeneous agents

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  • Guasoni, Paolo
  • Weber, Marko Hans

Abstract

This paper examines the implications of unhedgeable fundamental risk, combined with agents' heterogeneous preferences and wealth allocations, on dynamic asset pricing and portfolio choice. We solve in closed form a continuous-time general equilibrium model in which unhedgeable fundamental risk affects aggregate consumption dynamics, rendering the market incomplete. Several long-lived agents with heterogeneous risk-aversion and time-preference make consumption and investment decisions, trading risky assets and borrowing from and lending to each other. We find that a representative agent does not exist. Agents trade assets dynamically. Their consumption rates depend on the history of unhedgeable shocks. Consumption volatility is higher for agents with preferences and wealth allocations deviating more from the average. Unhedgeable risk reduces the equilibrium interest rate only through agents' heterogeneity and proportionally to the cross-sectional variance of agents' preferences and allocations.

Suggested Citation

  • Guasoni, Paolo & Weber, Marko Hans, 2025. "General equilibrium with unhedgeable fundamentals and heterogeneous agents," Journal of Economic Theory, Elsevier, vol. 224(C).
    • Handle: RePEc:eee:jetheo:v:224:y:2025:i:c:s0022053125000249
    DOI: 10.1016/j.jet.2025.105978
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    Keywords

    Equilibrium; Incomplete markets; Heterogeneous preferences; Continuous time;
    All these keywords.

    JEL classification:

    • D51 - Microeconomics - - General Equilibrium and Disequilibrium - - - Exchange and Production Economies
    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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