Limited Enforcement of Debt Contracts and Macroeconomic Implications for Asset Prices

Introduction Asset pricing is a topic of utmost interest in financial economics. Asset pricing models aim at determining the prices of financial assets such as stocks and bonds. One of the most interesting advances in asset pricing theory over the last three decades is the development of the consumption-based asset pricing model, a model that establishes a link between asset returns and macroeconomics (strictly speaking, consumption growth). Within such models, prices and returns of financial assets are determined by individuals’ consumption and saving choices, and hence by their preferences, their level of risk aversion and their degree of intertemporal substitutability. The first and canonical consumption-based asset pricing model is attrib- uted to Lucas [36]. Lucas’s model analyzes consumption and investment choices of a representative agent over an infinite horizon. In each period, the agent must decide his consumption and his investment so as to maxi- mize his expected intertemporal utility, E {∑∞ t=0 β tu(ct) } . He can invest in two types of financial assets: equity stocks, whose return is uncertain, and bonds, whose return is fixed and certain. At optimum, the loss in marginal utility incurred by sacrificing a unit of current consumption in order to pur- chase an additional unit of equity must equal the discounted expected gain in marginal utility resulting from the investment. 1