Asset and Derivative Pricing with Incomplete Markets

This paper presents a model where uninsurable income shocks and credit constraints generate a demand for liquidity. Infinitely lived agents purchase a risky asset to self insure themselves against their individual risk. They also trade call options to diversify the aggregate risk they face. In this economy, options are not redundant but complete the market for aggregate risk. We are able to characterize analytically both equilibrium prices and quantities of the underlying asset and associated options. The underlying asset volatility affects the prices and the traded volume of options, consistently with empirical findings. In addition, the introduction of options completing the market increases the ex ante welfare and decreases inequalities across agents.