Resolving asset pricing puzzles using price-impact

TL;DR

This paper presents a closed-form equilibrium model with price-impact among exponential investors, demonstrating how price-impact amplifies risk-sharing distortions and helps resolve key puzzles in asset pricing such as interest rates and stock volatility.

Contribution

It introduces a novel closed-form equilibrium model incorporating price-impact, revealing its role in resolving major asset pricing puzzles.

Findings

Price-impact amplifies risk-sharing distortions.

The model helps resolve the interest rate puzzle.

It also addresses the stock-price volatility puzzle.

Abstract

We solve in closed-form an equilibrium model in which a finite number of exponential investors continuously consume and trade with price-impact. Compared to the analogous Pareto-efficient equilibrium model, price-impact has an amplification effect on risk-sharing distortions that helps resolve the interest rate puzzle and the stock-price volatility puzzle and, to a lesser extent, affects the equity premium puzzle.