Asset Demands of Heterogeneous Consumers with Uninsurable Idiosyncratic Risk

We examine asset market equilibrium in a dynamic economic model with individual and aggregate uncertainty and where the asset market is incomplete. Modigliani-Miller leverage irrelevance holds, even when consumers face borrowing constraints, because individual firms cannot alter the equilibrium portfolio of securities available to consumers. We show that households demand less risky portfolios as their financial wealth increases because a given asymmetry in asset holdings imparts more variability to income when wealth is high. Finally, we confirm previous results that endogenous rates of time preference, uninsurable idiosyncratic risk and household borrowing constraints produce a very low risk-free real interest rate.