Asset pricing in a pure exchange economy with heterogeneous investors

In this paper, we provide a complete solution to the problem of equilibrium asset pricing in a pure exchange economy with two types of heterogeneous investors having higher/lower risk aversion. Using a perturbation method, we obtain analytical approximate formulas for the optimal consumption-sharing rule, which is numerically justified to be accurate for a large risk aversion and heterogeneity. We present analytical formulas for the equilibrium pricing function, Sharpe ratio, risk-free rate, stock price and optimal trading strategies. We then analyse the properties of the equilibrium and derive some testable hypotheses, which enhance our understanding on the economics of financial markets.