Efficiency, equilibrium and asset pricing with risk of default, Econometrica 68

We introduce a new equilibrium concept and study its e¢ciency and asset pricing implications for the environment analyzed by Kehoe and Levine (1993) and Kocherlakota (1996). Our equilibrium concept has complete markets and endogenous solvency constraints. These sol-vency constraints prevent default at the cost of reducing risk sharing. We show versions of the welfare theorems. We characterize the pref-erences and endowments that lead to equilibria with incomplete risk sharing. We compare the resulting pricing kernel with the one for economies without participation constraints: interest rates are lower and risk premia depend on the covariance of the idiosyncratic and ag-gregate shocks. Additionally, we show that asset prices depend only on the valuation of agents with substantial idiosyncratic risk. ¤Earlier versions of this paper have been circulated under the title “Asset pricing when risk sharing is limited by default. ” This paper has bene…tted from comments b