Aggregate Implications of Micro Asset Market Segmentation∗

This paper develops a consumption-based asset pricing model to explain and quantify the aggregate implications of a frictional financial system, comprised of many financial markets partially integrated with one-another. Each of our micro financial markets is inhabited by traders who are specialized in that market’s type of asset. We specify exogenously the level of segmentation that ultimately determines how much idiosyncratic risk traders bear in their micro market and derive aggregate asset pricing implications. We pick segmentation parameters to match facts about systematic and idiosyncratic return volatility. We find that if the same level of segmentation prevails in every market, traders bear 20% of their idiosyncratic risk. With otherwise standard parameters, this benchmark model delivers an unconditional equity premium of 3.7% annual. We further disaggregate the model by allowing the level of segmentation to differ across markets. This version of the model delivers the same aggregate asset pricing implications but with only half the amount of segmentation: on average traders bear 10% of their idiosyncratic risk.