Incentive Constrained Risk Sharing, Segmentation, and Asset Pricing (with Bruno Biais and Pierre-Olivier Weill)

Abstract:
We analyse a one-period general equilibrium asset pricing model with standard corporate finance frictions (cash-diversion). Incentive compatibility constraints imply that the market is endogenous incomplete. They also induce endogenous segmentation, as different types of investors hold different assets in equilibrium, and co-movements in asset prices. Equilibrium expected excess returns reflect two premia: a risk premium, which is positive if the return on the asset is large when the pricing kernel is low, but which does not reflect aggregate or individual consumption due to incentive compatibility constraints; and a divertibility premium, which is positive if the return on the asset large when incentive-compatibility constraints bind. This divertibility premium is inverse-U shaped with betas, in line with the empirical findings that the security market line is flat at the top.