This paper examines the effects of incomplete markets on risk sharing and asset pricing. Agents in the model face both aggregate and idiosyncratic income shocks and can reduce consumption variability by trading in a stock and bond market, but transactions costs limit the extent of trade. The model is calibrated using an empirical model of labor and dividend income, estimated from data from the Panel Study of Income Dynamics (PSID) and the National Income and Product Accounts (NIPA). Despite agents being not very risk averse, the model predicts a significant equity premium and a low risk-free rate. The effect of transactions costs on the equity premium is decomposed into two components: a direct effect due to net-of-cost margins and an indirect effect due to increased consumption volatility. The direct effect is significant when there is a wedge between the borrowing and lending rates or a binding borrowing constraint, while the indirect effect is more pronounced in models with cyclical distribution of labor income shocks. The results suggest that incomplete markets and transactions costs can explain the equity premium puzzle and the low risk-free rate observed in financial markets.This paper examines the effects of incomplete markets on risk sharing and asset pricing. Agents in the model face both aggregate and idiosyncratic income shocks and can reduce consumption variability by trading in a stock and bond market, but transactions costs limit the extent of trade. The model is calibrated using an empirical model of labor and dividend income, estimated from data from the Panel Study of Income Dynamics (PSID) and the National Income and Product Accounts (NIPA). Despite agents being not very risk averse, the model predicts a significant equity premium and a low risk-free rate. The effect of transactions costs on the equity premium is decomposed into two components: a direct effect due to net-of-cost margins and an indirect effect due to increased consumption volatility. The direct effect is significant when there is a wedge between the borrowing and lending rates or a binding borrowing constraint, while the indirect effect is more pronounced in models with cyclical distribution of labor income shocks. The results suggest that incomplete markets and transactions costs can explain the equity premium puzzle and the low risk-free rate observed in financial markets.