Asset Prices in a Huggett Economy

This paper explores the asset-price implications in economies where there is no direct insurance against idiosyncratic risks but there are other assets---such as a riskfree bond or equity---that can be used for self-insurance, subject to exogenously imposed borrowing limits. We analyze an economy without production---an endowment economy---and we consider both the case with no aggregate risk and the case with aggregate risk. Thus, we analyze the economy originally studied, in the case without aggregate risk, in Huggett (1993). Our main innovation is that, by studying the case with ``maximally tight'' borrowing constraints, we can obtain full analytical tractability. Thus, like in Lucas's seminal asset-pricing paper, we obtain closed forms for all state-contingent claims, allowing us to study the price determination for all assets with payoffs contingent on aggregate events. In the Huggett economy, like in Lucas's, any asset pricing is obtained using a first-order condition, but in the Huggett economy only a subset of the consumers will typically have first-order constraints holding with equality---the others are borrowing-constrained. Thus, the analysis centers around who prices the assets, and around what the endowment risks of this agent are; in the Lucas economy, only the aggregate endowment risk matters. Moreover, identity/type of the consumer pricing an asset may change over time. We specifically illustrate by looking at riskless bonds, equity, and the term structure of interest rates.