Valuing Government Obligations When Markets Are Incomplete

Abstract

We simulate a 10-period overlapping generations model with aggregate shocks to price safe and risky government obligations using consumption-asset pricing. Agents cannot trade with future generations to hedge the model's productivity and depreciation shocks, and can only invest in one-period bonds and risky capital. We find that the pricing of short- and long-dated riskless obligations is anchored to the prevailing risk-free return. The prices of obligations whose values are proportional to the prevailing wage are essentially identical to those of safe obligations, notwithstanding large macro shocks. On the contrary, government obligations in the form of options entail significant risk adjustment.