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Private risk premium and aggregate uncertainty in the model of uninsurable investment risk

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Francisco Covas
Shigeru Fujita

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Abstract

This paper studies cyclical properties of the private risk premium in a model where a continuum of heterogeneous entrepreneurs are subject to aggregate as well as idiosyncratic risks, both of which are assumed to be highly persistent. The calibrated model matches highly skewed wealth and income distributions of entrepreneurs found in the Survey of Consumer Finances. The authors provide an accurate numerical solution to the model even though the model is shown to exhibit serious nonlinearities that are absent in incomplete market models with idiosyncratic labor income risk. The model is able to generate the aggregate private risk premium of 2-3 percent and the low risk-free rate. However, it generates very little variation in these variables over the business cycle, suggesting that the model lacks the ability to amplify aggregate shocks.

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Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 07-30.

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Date of creation: 2007
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Handle: RePEc:fip:fedpwp:07-30

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  3. Tobias J. Moskowitz & Annette Vissing-Jørgensen, 2002. "The Returns to Entrepreneurial Investment: A Private Equity Premium Puzzle?," American Economic Review, American Economic Association, vol. 92(4), pages 745-778, September. [Downloadable!]
  4. Francisco Covas, 2005. "Uninsured Idiosyncratic Production Risk With Borrowing Constraints," Computing in Economics and Finance 2005 198, Society for Computational Economics.
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  5. Kjetil Storesletten & Chris I. Telmer & Amir Yaron, 2004. "Cyclical Dynamics in Idiosyncratic Labor Market Risk," Journal of Political Economy, University of Chicago Press, vol. 112(3), pages 695-717, June.
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  7. Meh, Césaire A. & Quadrini, Vincenzo, 2004. "Endogenous Market Incompleteness with Investment Risks," CEPR Discussion Papers 4807, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  8. William M. Gentry & R. Glenn Hubbard, 2000. "Entrepreneurship and Household Saving," NBER Working Papers 7894, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  9. Telmer, Chris I. & Zin, Stanley E., 2002. "Prices as factors: Approximate aggregation with incomplete markets," Journal of Economic Dynamics and Control, Elsevier, vol. 26(7-8), pages 1127-1157, July. [Downloadable!] (restricted)
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  11. John Heaton & Deborah Lucas, 2000. "Portfolio Choice and Asset Prices: The Importance of Entrepreneurial Risk," Journal of Finance, American Finance Association, vol. 55(3), pages 1163-1198, 06. [Downloadable!] (restricted)
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  14. Per Krusell & Anthony A. Smith & Jr., 1998. "Income and Wealth Heterogeneity in the Macroeconomy," Journal of Political Economy, University of Chicago Press, vol. 106(5), pages 867-896, October. [Downloadable!] (restricted)
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  15. Lu Zhang, 2005. "The Value Premium," Journal of Finance, American Finance Association, vol. 60(1), pages 67-103, 02. [Downloadable!] (restricted)
  16. Gomes, Francisco J & Michaelides, Alexander, 2007. "Asset Pricing with Limited Risk Sharing and Heterogeneous Agents," CEPR Discussion Papers 6136, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  17. Yaz Terajima, 2006. "Education and Self-Employment: Changes in Earnings and Wealth Inequality," Working Papers 06-40, Bank of Canada. [Downloadable!]
  18. Robert E. Lucas Jr., 1978. "On the Size Distribution of Business Firms," Bell Journal of Economics, The RAND Corporation, vol. 9(2), pages 508-523, Autumn. [Downloadable!] (restricted)
  19. Fatih Guvenen & Burhanettin Kuruscu, 2006. "Does Market Incompleteness Matter for Asset Prices?," Journal of the European Economic Association, MIT Press, vol. 4(2-3), pages 484-492, 04-05. [Downloadable!] (restricted)
  20. Tobias J. Moskowitz & Annette Vissing-Jorgensen, 2002. "The Returns to Entrepreneurial Investment: A Private Equity Premium Puzzle?," NBER Working Papers 8876, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  21. repec:cup:macdyn:v:1:y:1997:i:2:p:355-86 is not listed on IDEAS
  22. Wouter J. den Haan & Albert Marcet, 1993. "Accuracy in Simulations," Economics Working Papers 42, Department of Economics and Business, Universitat Pompeu Fabra. [Downloadable!]
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  23. Eric R Young, 2005. "Approximate Aggregation," Computing in Economics and Finance 2005 141, Society for Computational Economics. [Downloadable!]
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  24. Barton H. Hamilton, 2000. "Does Entrepreneurship Pay? An Empirical Analysis of the Returns to Self-Employment," Journal of Political Economy, University of Chicago Press, vol. 108(3), pages 604-631, June. [Downloadable!] (restricted)
  25. Aiyagari, S Rao, 1994. "Uninsured Idiosyncratic Risk and Aggregate Saving," The Quarterly Journal of Economics, MIT Press, vol. 109(3), pages 659-84, August. [Downloadable!] (restricted)
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  26. George-Marios Angeletos & Laurent Calvet, 2003. "Idiosyncratic Production Risk, Growth, and the Business Cycle," NBER Working Papers 9764, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  27. Aubhik Khan & Julia Thomas, 2007. "Idiosyncratic Shocks and the Role of Nonconvexities in Plant and Aggregate Investment Dynamics," NBER Working Papers 12845, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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