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Idiosyncratic Risk and Volatility Bounds, or, Can Models with Idiosyncratic Risk Solve the Equity Premium Puzzle?

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  • Lettau, Martin

Abstract

This paper evaluates models with idiosyncratic consumption risk using Hansen and Jagannathan’s (1991) volatility bounds. It is shown that idiosyncratic risk does not change the volatility bounds at all when consumers have constant relative risk aversion (CRRA) preferences and the distribution of the idiosyncratic shock is independent of the aggregate state. Following Mankiw (1986), I 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 is not reliable, I compute an upper bound of the volatility bounds using individual income data and assume that agents must consume their endowment. I find that the model does not pass the Hansen and Jagannathan test even for very volatile idiosyncratic income data.

Suggested Citation

  • Lettau, Martin, 1998. "Idiosyncratic Risk and Volatility Bounds, or, Can Models with Idiosyncratic Risk Solve the Equity Premium Puzzle?," CEPR Discussion Papers 1795, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:1795
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    Cited by:

    1. YiLi Chien & Hanno Lustig, 2010. "The Market Price of Aggregate Risk and the Wealth Distribution," The Review of Financial Studies, Society for Financial Studies, vol. 23(4), pages 1596-1650, April.
    2. Paul Söderlind, 2006. "C-CAPM Refinements and the Cross-Section of Returns," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 20(1), pages 49-73, April.
    3. Andrei Semenov, 2003. "High-Order Consumption Moments and Asset Pricing," Working Papers 2003_4, York University, Department of Economics, revised Jan 2005.
    4. Söderlind, Paul, 2003. "C-CAPM and the Cross-Section of Sharpe Ratios," SIFR Research Report Series 18, Institute for Financial Research.
    5. Hanno Lustig, "undated". "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.

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    Keywords

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    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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