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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.

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

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Date of creation: Jan 1998
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Handle: RePEc:cpr:ceprdp:1795
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  1. Phillippe Weil, 1997. "The Equity Premium Puzzle and the Risk-Free Rate Puzzle," Levine's Working Paper Archive 1833, David K. Levine.
  2. Aiyagari, S. Rao & Gertler, Mark, 1991. "Asset returns with transactions costs and uninsured individual risk," Journal of Monetary Economics, Elsevier, vol. 27(3), pages 311-331, June.
  3. 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.
  4. 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.
  5. 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.
  6. N. Gregory Mankiw, 1986. "The Equity Premium and the Concentration of Aggregate Shocks," NBER Working Papers 1788, National Bureau of Economic Research, Inc.
  7. John H. Cochrane & Lars Peter Hansen, 1992. "Asset Pricing Explorations for Macroeconomics," NBER Working Papers 4088, National Bureau of Economic Research, Inc.
  8. 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.
  9. Hansen, Lars Peter & Jagannathan, Ravi, 1991. "Implications of Security Market Data for Models of Dynamic Economies," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 225-62, April.
  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.
  11. Miles S. Kimball, 1989. "Precautionary Saving in the Small and in the Large," NBER Working Papers 2848, National Bureau of Economic Research, Inc.
  12. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  13. 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.
  14. 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.
  15. 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.
  16. Deaton, Angus, 1992. "Understanding Consumption," OUP Catalogue, Oxford University Press, number 9780198288244.
  17. 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.
  18. 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.
  19. Philippe Weil, 1992. "Equilibrium Asset Prices With Undiversifiable Labor Income Risk," NBER Working Papers 3975, National Bureau of Economic Research, Inc.
  20. 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.
  21. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  22. Kjetil Storesletten & Chris Telmer & Amir Yaron, . "Persistent Idiosyncratic Shocks and Incomplete Markets," GSIA Working Papers 24, Carnegie Mellon University, Tepper School of Business.
  23. 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.
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