Idiosyncratic Risk, Borrowing Constraints and Asset Prices

This paper joins the standard consumption‐based asset‐pricing model (Lucas 1978) with a Bewley‐type model of self‐insurance (Bewley 1983) in order to analyse the interaction of systemic and idiosyncratic risk in determining the structure of asset prices. The model suggests that idiosyncratic risk affects asset prices both through a direct price effect and an indirect portfolio composition effect which may offset the price effect. The quantitative importance of these two effects is shown to depend on parameters of the model which have not previously been the focus of simulation studies.