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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. Abowd, John M & Card, David, 1989. "On the Covariance Structure of Earnings and Hours Changes," Econometrica, Econometric Society, vol. 57(2), pages 411-45, March.
  2. 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.
  3. Deaton, Angus, 1992. "Understanding Consumption," OUP Catalogue, Oxford University Press, number 9780198288244, October.
  4. N. Gregory Mankiw, 1986. "The Equity Premium and the Concentration of Aggregate Shocks," NBER Working Papers 1788, National Bureau of Economic Research, Inc.
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  9. 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.
  10. Lucas, Deborah J., 1994. "Asset pricing with undiversifiable income risk and short sales constraints: Deepening the equity premium puzzle," Journal of Monetary Economics, Elsevier, vol. 34(3), pages 325-341, December.
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  17. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  18. 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.
  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.
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  21. Constantinides,George & Duffie,Darrel, 1992. "Asset pricing with heterogeneous consumers," Discussion Paper Serie A 381, University of Bonn, Germany.
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Cited by:
  1. Andrei Semenov, 2004. "High-Order Consumption Moments and Asset Pricing," Econometric Society 2004 North American Winter Meetings 130, Econometric Society.
  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. Hanno Lustig, 2001. "The Market Price of Aggregate Risk and the Wealth Distribution," Finance 0111004, EconWPA, revised 16 Nov 2001.
  4. Paul Söderlind, 2006. "C-CAPM Refinements and the Cross-Section of Returns," University of St. Gallen Department of Economics working paper series 2006 2006-07, Department of Economics, University of St. Gallen.
  5. Söderlind, Paul, 2003. "C-CAPM and the Cross-Section of Sharpe Ratios," CEPR Discussion Papers 4067, C.E.P.R. Discussion Papers.

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