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Asset pricing with idiosyncratic risk and overlapping generations

  • Storesletten, Kjetil

    ()

    (Institute for International Economic Studies, Stockholm University)

  • Telmer, Chris

    ()

    (Graduate School of Industrial Administration, Carnegie Mellon University)

  • Yaron, Amir

    ()

    (Wharton School, University of Pennsylvania)

Constantinides and Duffie (1996) show that for idiosynratic risk to matter for asset pricing the shocks must (i) be highly persistent and (ii) become more volatile during economic contractions. We show that data from the Panel Study on Income Dynamics (PSID) are consistent with these requirements. Our results are based on econometric methods which incorporate macroeconomic information going beyond the time horizon of the PSID, dating back to 1910. We go on to argue that life-cycles effects are fundamental for how idiosyncratic risk affects asset pricing. We use a stationary overlapping-generations model to show that life-cycle effects can either mitigate or accentuate the equity premium, the critical ingredient being whether agents accumulate or deccumulate risky assets as they age. Our model predicts the latter and is able to account for both the average equity premium and the Sharpe ratio observed on the U.S. stock market.

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Paper provided by Stockholm University, Institute for International Economic Studies in its series Seminar Papers with number 703.

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Length: 56 pages
Date of creation: 12 Feb 2002
Date of revision:
Handle: RePEc:hhs:iiessp:0703
Contact details of provider: Postal: Institute for International Economic Studies, Stockholm University, S-106 91 Stockholm, Sweden
Phone: +46-8-162000
Fax: +46-8-161443
Web page: http://www.iies.su.se/

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