Heterogeneous Preferences and Asset Prices under Endogenously Incomplete Markets

I study how heterogeneous preferences (heterogeneity in risk aversion and time discount factor) affect asset prices and risk sharing in endowment economy, when financial markets are endogenously incomplete due to the contracting friction of limited enforcement. I find that heterogeneous preferences lead to more conditional variation in the stochastic discount factor (SDF), which results in a higher and more volatile equity premium. In contrast to the standard findings under heterogeneous preferences, the long run distribution of agents’ consumption is stationary and nondegenerate, because limited enforcement entitles the agents to the option of autarky for all times.