IDEAS home Printed from
MyIDEAS: Log in (now much improved!) to save this paper

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

  • Lettau, Martin

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.

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL:
Download Restriction: CEPR Discussion Papers are free to download for our researchers, subscribers and members. If you fall into one of these categories but have trouble downloading our papers, please contact us at

As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 1795.

in new window

Date of creation: Jan 1998
Date of revision:
Handle: RePEc:cpr:ceprdp:1795
Contact details of provider: Postal:
Centre for Economic Policy Research, 77 Bastwick Street, London EC1V 3PZ.

Phone: 44 - 20 - 7183 8801
Fax: 44 - 20 - 7183 8820

Order Information: Email:

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

as in new window
  1. Cogley, Timothy, 2002. "Idiosyncratic risk and the equity premium: evidence from the consumer expenditure survey," Journal of Monetary Economics, Elsevier, vol. 49(2), pages 309-334, March.
  2. Hua He and David M. Modest., 1992. "Market Frictions and Consumption-Based Asset Pricing," Research Program in Finance Working Papers RPF-223, University of California at Berkeley.
  3. 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.
  4. 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, vol. 104(3), pages 443-87, June.
  5. Miles S. Kimball, 1989. "Precautionary Saving in the Small and in the Large," NBER Working Papers 2848, National Bureau of Economic Research, Inc.
  6. MaCurdy, Thomas E., 1982. "The use of time series processes to model the error structure of earnings in a longitudinal data analysis," Journal of Econometrics, Elsevier, vol. 18(1), pages 83-114, January.
  7. Lars Peter Hansen & Ravi Jagannathan, 1990. "Implications of Security Market Data for Models of Dynamic Economies," NBER Technical Working Papers 0089, National Bureau of Economic Research, Inc.
  8. 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.
  9. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  10. Aiyagari, S. Rao & Gertler, Mark, 1990. "Asset Returns With Transactions Costs And Uninsured Individual Risk: A Stage Iii Exercise," Working Papers 90-43, C.V. Starr Center for Applied Economics, New York University.
  11. Constantinides, George M & Duffie, Darrell, 1996. "Asset Pricing with Heterogeneous Consumers," Journal of Political Economy, University of Chicago Press, vol. 104(2), pages 219-40, April.
  12. Sydney C. Ludvigson & Alexander Michaelides, 2001. "Does Buffer-Stock Saving Explain the Smoothness and Excess Sensitivity of Consumption?," American Economic Review, American Economic Association, vol. 91(3), pages 631-647, June.
  13. Weil, Philippe, 1992. "Equilibrium asset prices with undiversifiable labor income risk," Journal of Economic Dynamics and Control, Elsevier, vol. 16(3-4), pages 769-790.
  14. Kjetil Storesletten & Chris Telmer & Amir Yaron, . "Persistent Idiosyncratic Shocks and Incomplete Markets," GSIA Working Papers 24, Carnegie Mellon University, Tepper School of Business.
  15. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  16. John M. Abowd & David Card, 1986. "On the Covariance Structure of Earnings and Hours Changes," NBER Working Papers 1832, National Bureau of Economic Research, Inc.
  17. Phillippe Weil, 1997. "The Equity Premium Puzzle and the Risk-Free Rate Puzzle," Levine's Working Paper Archive 1833, David K. Levine.
  18. N. Gregory Mankiw, 1986. "The Equity Premium and the Concentration of Aggregate Shocks," NBER Working Papers 1788, National Bureau of Economic Research, Inc.
  19. 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.
  20. S Rao Aiyagari & Mark Gertler, 1997. "Asset Returns with transaction costs and uninsured individual risk," Levine's Working Paper Archive 648, David K. Levine.
  21. Christopher D. Carroll, 1992. "The Buffer-Stock Theory of Saving: Some Macroeconomic Evidence," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 23(2), pages 61-156.
  22. 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.
  23. Deaton, Angus, 1992. "Understanding Consumption," OUP Catalogue, Oxford University Press, number 9780198288244, December.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:cpr:ceprdp:1795. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ()

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.