The market price of aggregate risk and the wealth distribution

"I introduce bankruptcy into a complete markets model with a continuum of ex ante identical agents who have power utility. Shares in a Lucas tree serve as collateral. The model yields a large equity premium, a low risk-free rate and a time-varying market price of risk for reasonable risk aversion. Bankruptcy gives rise to a second risk factor in addition to aggregate consumption growth risk. This liquidity risk is created by binding solvency constraints. The risk is measured by one moment of the wealth distribution, which multiplies the standard Breeden-Lucas stochastic discount factor. This captures the aggregate shadow cost of the solvency constraints. The economy is said to experience a negative liquidity shock when this growth rate is high and a large fraction of agents faces severely binding solvency constraints. These shocks occur in recessions. The average investor wants a high excess return on stocks to compensate for the extra liquidity risk, because of low stock returns in recessions. In that sense stocks are "bad collateral". The adjustment to the Breeden-Lucas stochastic discount factor raises the unconditional risk premium and induces time variation in conditional risk premia"--National Bureau of Economic Research web site.