Up to this point, our discussion has been based on frictionless trading in a representative consumer context. In Chapter 2, we argued that trading frictions such as short sales constraints or transactions costs can alter the implications of a variety of asset-pricing relations. As an example, we showed that in the presence of such frictions, a strict form of the Law of One Price may fail to hold. In this chapter, we will introduce such frictions into asset-pricing models and discuss some of the empirical implications. We will also consider some of the empirical implications of allowing for market incompleteness for asset-pricing phenomena. Various authors have noted that such models have the potential to account for a variety of economic phenomena that cannot be explained easily using the simple representative consumer economies that we have studied so far.

As our earlier discussion indicates, resolution of such asset-pricing anomalies as the “equity premium puzzle,” the “real risk-free rate puzzle,” and the behavior of the term premiums may lie in the relaxation of the representative consumer, complete markets assumption. In a representative agent model, all asset returns are driven by a common stochastic discount factor which suggests that, to some extent, stocks and bonds should tend to move together. Yet the empirical evidence appears to be at odds with this requirement.1 By introducing market incompleteness, borrowing constraints, and other sorts of frictions, some have suggested that this close link can be broken.