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Idiosyncratic risk and volatility bounds, or can models with idiosyncratic risk solve the equity premium puzzle?

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  • Martin Lettau

Abstract

This paper uses Hansen and Jagannathan's (1991) volatility bounds to evaluate models with idiosyncratic consumption risk. I show that idiosyncratic risk does not change the volatility bounds at all when consumers have CRRA preferences and the distribution of the idiosyncratic shock is independent of the aggregate state. Following Mankiw (1986), I then show that idiosyncratic risk can help to enter the bounds when idiosyncratic uncertainty depends on the aggregate state of the economy. Since individual consumption data are not reliable, I compute an upper bound of the volatility bounds using individual income data and assume that agents have to consume their endowment. I find that the model does not pass the Hansen and Jagannathan test even for very volatile idiosyncratic income data.

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Bibliographic Info

Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 130.

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Date of creation: 2001
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Handle: RePEc:fip:fednsr:130

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Keywords: Risk ; Income ; Econometric models ; Consumption (Economics) ; Asset pricing;

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  1. John Y. Campbell & N. Gregory Mankiw, 1989. "Consumption, Income, and Interest Rates: Reinterpreting the Time Series Evidence," NBER Working Papers 2924, National Bureau of Economic Research, Inc.
  2. John H. Cochrane & Lars Peter Hansen, 1992. "Asset Pricing Explorations for Macroeconomics," NBER Chapters, in: NBER Macroeconomics Annual 1992, Volume 7, pages 115-182 National Bureau of Economic Research, Inc.
  3. Philippe Weil, 1992. "Equilibrium Asset Prices With Undiversifiable Labor Income Risk," NBER Working Papers 3975, National Bureau of Economic Research, Inc.
  4. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  5. 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.
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  7. Constantinides,George & Duffie,Darrel, 1992. "Asset pricing with heterogeneous consumers," Discussion Paper Serie A 381, University of Bonn, Germany.
  8. Lars Peter Hansen & Ravi Jagannathan, 1990. "Implications of security market data for models of dynamic economies," Discussion Paper / Institute for Empirical Macroeconomics 29, Federal Reserve Bank of Minneapolis.
  9. Wouter J. Den Haan, 1996. "Understanding Equilibrium Models with a Small and a Large Number of Agents," NBER Working Papers 5792, National Bureau of Economic Research, Inc.
  10. He, Hua & Modest, David M, 1995. "Market Frictions and Consumption-Based Asset Pricing," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 103(1), pages 94-117, February.
  11. 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.
  12. Kimball, Miles S, 1990. "Precautionary Saving in the Small and in the Large," Econometrica, Econometric Society, Econometric Society, vol. 58(1), pages 53-73, January.
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  14. 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.
  15. Sydney C. Ludvigson & Alexander Michaelides, 2001. "Does Buffer-Stock Saving Explain the Smoothness and Excess Sensitivity of Consumption?," American Economic Review, American Economic Association, American Economic Association, vol. 91(3), pages 631-647, June.
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  17. Heaton, John & Lucas, Deborah J, 1996. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 104(3), pages 443-87, June.
  18. 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.
  19. Timothy Cogley, 1998. "Idiosyncratic risk and the equity premium: evidence from the Consumer Expenditure Survey," Working Papers in Applied Economic Theory 98-07, Federal Reserve Bank of San Francisco.
  20. Deaton, Angus, 1992. "Understanding Consumption," OUP Catalogue, Oxford University Press, Oxford University Press, number 9780198288244, October.
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Citations

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Cited by:
  1. Paul Söderlind, 2006. "C-CAPM Refinements and the Cross-Section of Returns," University of St. Gallen Department of Economics working paper series 2006, Department of Economics, University of St. Gallen 2006-07, Department of Economics, University of St. Gallen.
  2. Hanno Lustig, . "When is Market Incompleteness Irrelevant for the Price of Aggregate Risk (joint with Dirk Krueger, UPenn)," UCLA Economics Online Papers 380, UCLA Department of Economics.
  3. YiLi Chien & Hanno Lustig, 2010. "The Market Price of Aggregate Risk and the Wealth Distribution," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 23(4), pages 1596-1650, April.
  4. Söderlind, Paul, 2003. "C-CAPM and the Cross-Section of Sharpe Ratios," CEPR Discussion Papers, C.E.P.R. Discussion Papers 4067, C.E.P.R. Discussion Papers.
  5. Andrei Semenov, 2004. "High-Order Consumption Moments and Asset Pricing," Econometric Society 2004 North American Winter Meetings 130, Econometric Society.

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