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Can Models with Idiosyncratic Risk Solve the Equity Premium Puzzle? Redux

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Abstract

Can idiosyncratic risk explain the equity premium? We revisit this question using a novel measure of imperfect risk sharing, implied by a large class of heterogeneous-agent models, constructed using household-level panel data. We identify a group of households – with relatively high income but low net worth – whose consumption is sufficiently volatile and risky to explain 94% of the observed U.S. Sharpe ratio. In contrast, the consumption dynamics of high net-worth individuals predict a negative Sharpe ratio and so do not constitute the relevant pricing factor, consistent with models featuring wealth motives.

Suggested Citation

  • Gleb Kozliakov & Emile A. Marin & Sanjay R. Singh, 2026. "Can Models with Idiosyncratic Risk Solve the Equity Premium Puzzle? Redux," Working Paper Series 2026-06, Federal Reserve Bank of San Francisco.
    • Handle: RePEc:fip:fedfwp:103059
    DOI: 10.24148/wp2026-06
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    Keywords

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    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • B52 - Schools of Economic Thought and Methodology - - Current Heterodox Approaches - - - Historical; Institutional; Evolutionary; Modern Monetary Theory;
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth

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