The impact of uninsurable risk on asset prices and optimal dividend policy
This thesis examines whether two well documented financial market anomalies - the "Mehra & Prescott puzzles" and the dividend controversy - can be resolved by allowing for the effects of uninsurable risks. The dissertation contains an extensive review of the theory of consumption based asset pricing and the Mehra & Prescott puzzles. This provides more comprehensive coverage of this material than any previous review of the area: see chapters 2 & 3. The role that uninsurable risk might play in resolving market anomalies is clearly demonstrated. Three chapters of substantive original contribution follow that examine: (i) the predicted equity premium when marketable and nonmarketable risks are independent (ii) the potential relevance of aggregate dividends to equilibrium asset prices in economies with idiosyncratic endowment shocks and (iii) the response of the stock market and riskfree rate to unemployment shocks. The main findings are: (i) Chapter 4: an integrated approach to local proper risk aversion is presented and a new form of risk aversion emerges naturally (ii) Chapter 4: it will not, in general, be possible to make accurate quantitative predictions concerning the impact of a small probability, high impact, negative shock to endowment ("unemployment") on asset prices on the basis of current knowledge concerning investor preferences (iii) Chapter 5: aggregate dividends are shown to play an important role in helping individuals to consumption smooth in incomplete markets if the level of aggregate investment is uncertain. The observed behaviour of dividend smoothing and concentrating rights issues into times of economic prosperity is consistent with the model that is presented (iv) Chapter 6: the rise (fall) in the riskfree rate prior to "bad" ("good") unemployment news does not appear to be consistent with precautionary savings behaviour. It is concluded that, while incomplete market models have great theoretical strength and some empirical support, 'Current applications of this theory leave many issues unresolved.