Advanced Search
MyIDEAS: Login to save this article or follow this journal

Asset Pricing with Idiosyncratic Risk and Overlapping Generations

Contents:

Author Info

  • Kjetil Storesletten

    (University of Oslo)

  • Chris Telmer

    (Carnegie Mellon University)

  • Amir Yaron

    (University of Pennsylvania)

Abstract

What is the effect of non-tradeable idiosyncratic risk on asset-market risk premiums? Constantinides and Duffie (1996) and Mankiw (1986) have shown that risk premiums will increase if the idiosyncratic shocks become more volatile during economic contractions. We add two important ingredients to this relationship: (i) the life cycle, and (ii) capital accumulation. We show that in a realistically-calibrated life-cycle economy with production these ingredients mitigate the ability of idiosyncratic risk to account for the observed Sharpe ratio on U.S. equity. While the Constantinides-Duffie model can account for the U.S. value of 41% with a risk-aversion coefficient of 8, our model generates a Sharpe ratio of 33%, which is roughly half-way to the complete-markets value of 25%. Almost all of this reduction is due to capital accumulation. Life-cycle effects are important in our model - we demonstrate that idiosyncratic risk matters for asset pricing because it inhibits the intergenerational sharing of aggregate risk - but their net effect on the Sharpe ratio is small. (Copyright: Elsevier)

Download Info

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
File URL: http://dx.doi.org/10.1016/j.red.2007.02.004
Download Restriction: Access to full texts is restricted to ScienceDirect subscribers and institutional members. See http://www.sciencedirect.com/ for details.

As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.

Bibliographic Info

Article provided by Elsevier for the Society for Economic Dynamics in its journal Review of Economic Dynamics.

Volume (Year): 10 (2007)
Issue (Month): 4 (October)
Pages: 519-548

as in new window
Handle: RePEc:red:issued:06-70

Contact details of provider:
Postal: Review of Economic Dynamics Academic Press Editorial Office 525 "B" Street, Suite 1900 San Diego, CA 92101
Fax: 1-314-444-8731
Email:
Web page: http://www.EconomicDynamics.org/review.htm
More information through EDIRC

Order Information:
Email:
Web: http://www.EconomicDynamics.org/RED17.htm

Related research

Keywords: Idiosyncratic risk; Asset pricing; OLG;

Other versions of this item:

Find related papers by JEL classification:

References

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
as in new window
  1. Krusell, P & Smith Jr, A-A, 1995. "Income and Wealth Heterogeneity in the Macroeconomic," RCER Working Papers, University of Rochester - Center for Economic Research (RCER) 399, University of Rochester - Center for Economic Research (RCER).
  2. M. Fatih Guvenen, 2003. "A Parsimonious Macroeconomic Model for Asset Pricing: Habit Formation or Cross-sectional Heterogeneity?," RCER Working Papers, University of Rochester - Center for Economic Research (RCER) 499, University of Rochester - Center for Economic Research (RCER).
  3. George M. Constantinidies & John B. Donaldson & Rajnish Mehra, 1998. "Junior Can't Borrow: A New Perspective on the Equity Premium Puzzle," NBER Working Papers 6617, National Bureau of Economic Research, Inc.
  4. Marcet, Albert & Singleton, Kenneth J., 1999. "Equilibrium Asset Prices And Savings Of Heterogeneous Agents In The Presence Of Incomplete Markets And Portfolio Constraints," Macroeconomic Dynamics, Cambridge University Press, Cambridge University Press, vol. 3(02), pages 243-277, June.
  5. Storesletten, Kjetil, 1998. "Sustaining Fiscal Policy Through Immigration," Seminar Papers, Stockholm University, Institute for International Economic Studies 664, Stockholm University, Institute for International Economic Studies.
  6. Fernando Alvarez & Urban J. Jermann, 1999. "Quantitative asset pricing implications of endogenous solvency constraints," Working Papers 99-5, Federal Reserve Bank of Philadelphia.
  7. Deaton, A. & Paxson, C., 1993. "Intertemporal Choice and Inequality," Papers, Princeton, Woodrow Wilson School - Development Studies 168, Princeton, Woodrow Wilson School - Development Studies.
  8. S Rao Aiyagari & Mark Gertler, 1997. "Asset Returns with transaction costs and uninsured individual risk," Levine's Working Paper Archive 648, David K. Levine.
  9. Fernando Alvarez & Urban J. Jermann, 1998. "Asset Pricing when Risk Sharing is Limited by Default," NBER Working Papers 6476, National Bureau of Economic Research, Inc.
  10. Greenwood, J. & Hercowitz, Z. & Krusell, P., 1995. "Long-Run Implications of Investment-Specific Technological Change," UWO Department of Economics Working Papers, University of Western Ontario, Department of Economics 9510, University of Western Ontario, Department of Economics.
  11. Den Haan, Wouter J., 1997. "Solving Dynamic Models With Aggregate Shocks And Heterogeneous Agents," Macroeconomic Dynamics, Cambridge University Press, Cambridge University Press, vol. 1(02), pages 355-386, June.
  12. Michele Boldrin & Lawrence J. Christiano & Jonas D.M. Fisher, 1999. "Habit persistence, asset returns and the business cycles," Working Paper Series, Federal Reserve Bank of Chicago WP-99-14, Federal Reserve Bank of Chicago.
  13. L. Wade, 1988. "Review," Public Choice, Springer, Springer, vol. 58(1), pages 99-100, July.
  14. Weil, Philippe, 1992. "Equilibrium asset prices with undiversifiable labor income risk," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 16(3-4), pages 769-790.
  15. S. Rao Aiyagari & Mark Gertler, 1990. "Asset Returns with Transactions Cost and Uninsured Risk: A Stage III Exercise," NBER Working Papers 3481, National Bureau of Economic Research, Inc.
  16. John Heaton & Deborah Lucas, 1993. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," NBER Working Papers 4249, National Bureau of Economic Research, Inc.
  17. S. Rao Aiyagari, 1993. "Uninsured idiosyncratic risk and aggregate saving," Working Papers, Federal Reserve Bank of Minneapolis 502, Federal Reserve Bank of Minneapolis.
  18. Mankiw, N. Gregory, 1986. "The equity premium and the concentration of aggregate shocks," Journal of Financial Economics, Elsevier, Elsevier, vol. 17(1), pages 211-219, September.
  19. Per Krusell & Anthony A. Smith, Jr., . "Income and Wealth Heterogeneity, Portfolio Choice, and Equilibrium Asset Returns," GSIA Working Papers, Carnegie Mellon University, Tepper School of Business 1997-45, Carnegie Mellon University, Tepper School of Business.
  20. Robert J. Gordon, 1986. "The American Business Cycle: Continuity and Change," NBER Books, National Bureau of Economic Research, Inc, National Bureau of Economic Research, Inc, number gord86-1.
  21. Alon Brav & George M. Constantinides & Christopher C. Geczy, . "Asset Pricing with Heterogeneous Consumers and Limited Participation: Empirical Evidence," Rodney L. White Center for Financial Research Working Papers, Wharton School Rodney L. White Center for Financial Research 23-99, Wharton School Rodney L. White Center for Financial Research.
  22. Chris I. Telmer, 1991. "Asset Pricing Puzzles and Incomplete Markets," Working Papers, Queen's University, Department of Economics 806, Queen's University, Department of Economics.
  23. Mark Gertler, 1997. "Government Debt and Social Security in a Life-Cycle Economy," NBER Working Papers 6000, National Bureau of Economic Research, Inc.
  24. Greenwood, Jeremy & Hercowitz, Zvi & Huffman, Gregory W, 1988. "Investment, Capacity Utilization, and the Real Business Cycle," American Economic Review, American Economic Association, American Economic Association, vol. 78(3), pages 402-17, June.
  25. John M. Abowd & David Card, 1986. "On the Covariance Structure of Earnings and Hours Changes," NBER Working Papers 1832, National Bureau of Economic Research, Inc.
  26. Orazio Attanasio & Steven J. Davis, 1994. "Relative Wage Movements and the Distribution of Consumption," NBER Working Papers 4771, National Bureau of Economic Research, Inc.
  27. Fumio Hayashi & Joseph Altonji & Laurence Kotlikoff, 1991. "Risk-Sharing, Altruism, and the Factor Structure of Consumption," NBER Working Papers 3834, National Bureau of Economic Research, Inc.
  28. Dirk Kreuger & Fabrizio Perri, 2002. "Does Income Inequality Lead to Consumption Inequality? Evidence and Theory," Working Papers, New York University, Leonard N. Stern School of Business, Department of Economics 02-15, New York University, Leonard N. Stern School of Business, Department of Economics.
  29. Cogley, Timothy, 2002. "Idiosyncratic risk and the equity premium: evidence from the consumer expenditure survey," Journal of Monetary Economics, Elsevier, Elsevier, vol. 49(2), pages 309-334, March.
  30. Sumru Altug & Robert A. Miller, 1987. "Household choices in equilibrium," Working Papers, Federal Reserve Bank of Minneapolis 341, Federal Reserve Bank of Minneapolis.
  31. Huggett, Mark, 1996. "Wealth distribution in life-cycle economies," Journal of Monetary Economics, Elsevier, Elsevier, vol. 38(3), pages 469-494, December.
  32. Brown, David P, 1990. "Age Clienteles Induced by Liquidity Constraints," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 31(4), pages 891-912, November.
  33. Storesletten, Kjetil & Telmer, Christopher I. & Yaron, Amir, 2004. "Consumption and risk sharing over the life cycle," Journal of Monetary Economics, Elsevier, Elsevier, vol. 51(3), pages 609-633, April.
  34. N. Gregory Mankiw & Stephen P. Zeldes, 1990. "The Consumption of Stockholders and Non-Stockholders," NBER Working Papers 3402, National Bureau of Economic Research, Inc.
  35. Deaton, Angus, 1991. "Saving and Liquidity Constraints," Econometrica, Econometric Society, Econometric Society, vol. 59(5), pages 1221-48, September.
  36. Kjetil Storesletten & Chris I. Telmer & Amir Yaron, 2004. "Cyclical Dynamics in Idiosyncratic Labor Market Risk," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 112(3), pages 695-717, June.
  37. R. Glenn Hubbard & Jonathan Skinner & Stephen P. Zeldes, 1993. "The Importance of Precautionary Motives in Explaining Individual and Aggregate Saving," NBER Working Papers 4516, National Bureau of Economic Research, Inc.
  38. Rios-Rull, Jose-Victor, 1994. "On the quantitative importance of market completeness," Journal of Monetary Economics, Elsevier, Elsevier, vol. 34(3), pages 463-496, December.
  39. MaCurdy, Thomas E., 1982. "The use of time series processes to model the error structure of earnings in a longitudinal data analysis," Journal of Econometrics, Elsevier, Elsevier, vol. 18(1), pages 83-114, January.
  40. Zvi Bodie & Robert C. Merton & William F. Samuelson, 1992. "Labor Supply Flexibility and Portfolio Choice in a Life-Cycle Model," NBER Working Papers 3954, National Bureau of Economic Research, Inc.
  41. Constantinides,George & Duffie,Darrel, 1992. "Asset pricing with heterogeneous consumers," Discussion Paper Serie A, University of Bonn, Germany 381, University of Bonn, Germany.
  42. White, Halbert, 1980. "A Heteroskedasticity-Consistent Covariance Matrix Estimator and a Direct Test for Heteroskedasticity," Econometrica, Econometric Society, Econometric Society, vol. 48(4), pages 817-38, May.
  43. Lucas, Deborah J., 1994. "Asset pricing with undiversifiable income risk and short sales constraints: Deepening the equity premium puzzle," Journal of Monetary Economics, Elsevier, Elsevier, vol. 34(3), pages 325-341, December.
  44. Jonathan Heathcote & Kjetil Storesletten & Giovanni L. Violante, 2005. "Two Views of Inequality Over the Life Cycle," Journal of the European Economic Association, MIT Press, MIT Press, vol. 3(2-3), pages 765-775, 04/05.
  45. Ravi Jagannathan & Narayana R. Kocherlakota, 1996. "Why should older people invest less in stock than younger people?," Quarterly Review, Federal Reserve Bank of Minneapolis, Federal Reserve Bank of Minneapolis, issue Sum, pages 11-23.
  46. Huggett, Mark, 1993. "The risk-free rate in heterogeneous-agent incomplete-insurance economies," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 17(5-6), pages 953-969.
  47. Gomes, Francisco J & Michaelides, Alexander, 2007. "Asset Pricing with Limited Risk Sharing and Heterogeneous Agents," CEPR Discussion Papers, C.E.P.R. Discussion Papers 6136, C.E.P.R. Discussion Papers.
  48. John Heaton & Deborah Lucas, 2000. "Portfolio Choice and Asset Prices: The Importance of Entrepreneurial Risk," Journal of Finance, American Finance Association, American Finance Association, vol. 55(3), pages 1163-1198, 06.
  49. Zhang, Harold H, 1997. " Endogenous Borrowing Constraints with Incomplete Markets," Journal of Finance, American Finance Association, American Finance Association, vol. 52(5), pages 2187-2209, December.
  50. Sergei Sarkissian, 2003. "Incomplete Consumption Risk Sharing and Currency Risk Premiums," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 16(3), pages 983-1005, July.
Full references (including those not matched with items on IDEAS)

Citations

Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
as in new window

Cited by:
This item has more than 25 citations. To prevent cluttering this page, these citations are listed on a separate page.

Lists

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

Statistics

Access and download statistics

Corrections

When requesting a correction, please mention this item's handle: RePEc:red:issued:06-70. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Christian Zimmermann).

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.