Incomplete Continuous-time Securities Markets with Stochastic Income Volatility

Peter Ove Christensen, Kasper Larsen

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We derive closed-form solutions for the equilibrium interest rate and market price of risk processes in an incomplete continuous-time market with uncertainty generated by Brownian motions. The economy has a finite number of heterogeneous exponential utility investors, who receive partially unspanned income and can trade continuously. Countercyclical stochastic income volatility generates a countercyclical equilibrium market price of risk process and a procyclical equilibrium interest rate process. We show that when the investors' unspanned income volatility is countercyclical, the resulting equilibrium displays both lower interest rates and higher risk premia compared to the equilibrium in an otherwise identical complete market.
Original languageEnglish
JournalThe Review of Asset Pricing Studies
Issue number2
Pages (from-to)247-285
Number of pages39
Publication statusPublished - 2014
Externally publishedYes

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