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Idiosyncratic Risk and Higher-Order Cumulants

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Author Info

  • Lundtofte, Frederik

    ()
    (Department of Economics, Lund University)

  • Wilhelmsson, Anders

    ()
    (Department of Business Administration, Lund University)

Abstract

We show that, when allowing for general distributions of dividend growth in a Lucas economy with multiple "trees," idiosyncratic volatility will affect expected returns in ways that are not captured by the log linear approximation. We derive an exact expression for the risk premia for general distributions. Assuming growth rates are Normal Inverse Gaussian (NIG) and fitting the distribution to the data used in Mehra and Prescott (1985), the coefficient of relative risk aversion required to match the equity premium is more than halved compared to the finding in their article.

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File URL: http://project.nek.lu.se/publications/workpap/papers/WP11_33.pdf
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Bibliographic Info

Paper provided by Lund University, Department of Economics in its series Working Papers with number 2011:33.

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Length: 20 pages
Date of creation: 30 Sep 2011
Date of revision:
Handle: RePEc:hhs:lunewp:2011_033

Contact details of provider:
Postal: Department of Economics, School of Economics and Management, Lund University, Box 7082, S-220 07 Lund,Sweden
Phone: +46 +46 222 0000
Fax: +46 +46 2224613
Web page: http://www.nek.lu.se/en
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Keywords: diosyncratic risk; idiosyncratic volatility; risk premia; cumulants; NIG distribution;

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  1. Ian W. Martin, 2013. "Consumption-Based Asset Pricing with Higher Cumulants," Review of Economic Studies, Oxford University Press, vol. 80(2), pages 745-773.
  2. Ian Martin, 2013. "The Lucas Orchard," Econometrica, Econometric Society, vol. 81(1), pages 55-111, 01.
  3. Mahmoud Hamada & Emiliano A. Valdez, 2008. "CAPM and Option Pricing With Elliptically Contoured Distributions," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 75(2), pages 387-409.
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