Market incompleteness and the equity premium puzzle: Evidence from state-level data

This paper investigates the importance of market incompleteness by comparing the rates of risk aversion estimated from complete and incomplete markets environments. For the incomplete-markets case, we use consumption data for the 50 US states. We find that the rate of risk aversion under the incomplete-markets setup is much lower. Furthermore, including the second and third moments of the cross-sectional distribution of consumption growth in the pricing kernel lowers the estimate of risk aversion. These findings suggest that market incompleteness ought to be seen as an important component of solutions to the equity premium puzzle.