Risk Sharing in Economies with Incomplete Markets

This paper compares the degree to which a model with endogenous debt constraints versus a standard incomplete markets model can explain the lack of risk sharing observed in cross-section micro data. The model with endogenous debt constraints does not restrict the menu of tradeable assets, but assumes that contracts can only be enforced by the threat of exclusion from credit markets upon default. In the standard incomplete markets (bond) model households can only trade a one-period uncontingent bond, subject to an exogenous borrowing constraint. The quantitative risk sharing implications of parameterized versions of both models are derived and compared to those obtained from Consumer Expenditure Survey (CEX) data for 1986-94. The analysis indicates that the endogenous debt-constraint model captures the extent of risk sharing between households as measured in the CEX data better than the bond model.