ASSET PRICING IN HETEROGENEOUS ECONOMIES I. WEAK HETEROGENEITY

We extend the Lucas asset pricing tree economy to a heterogeneous population.Perturbative methods are applied to explicitly calculate the secondorder response of asset returns to heterogeneity. We discover thatthere exists a unique "best homogeneous approximation" to a weakly heterogeneouseconomy. We determine the status of various stylized facts.For example, we find that the equity premium always varies counter cyclically,the equity returns are always predictable and price dividend ratiosare positively autocorrelated. Moreover, sufficiently positive correlationbetween risk aversion and patience increases the risk premium and decreasesthe interest rate, thus giving another perspective on the equity premiumand the risk-free rate puzzles. This motivates us to make a concretesocial prediction. Finally, there is an open region of weakly heterogeneouseconomies where several other stylized facts hold.