Limited Capital Market Participation and Human Capital Risk

The non-tradability of human capital is often cited for the failure of traditional asset pricing theory to explain agents' portfolio holdings. In this paper we argue that the opposite might be true - traditional models might not be able to explain agent portfolio holdings because they do not explicitly account for the fact that human capital does trade (in the form of labor contracts). We derive wages endogenously as part of a dynamic equilibrium in a production economy. In equilibrium, firms write labor contracts that insure workers, allowing agents to achieve a Pareto optimal allocation even when the span of asset markets is restricted to just stocks and bonds. Capital markets facilitate this risk sharing because it is there that firms offload the labor market risk they assumed from workers. In effect, by investing in capital markets investors provide insurance to wage earners who then optimally choose not to participate in capital markets. The model is consistent with some of the most important stylized facts in asset pricing: (1) limited asset market participation, (2) a very large disparity in the volatility of consumption and the volatility of asset prices, (3) a time dependent correlation between consumption growth and asset returns, (4) a high market risk premium and (5) the failure of the CAPM to explain the cross-section of expected returns as well as a value premium in the cross-section of expected returns.