Idiosyncratic Risk and Higher-Order Cumulants
We show that, when allowing for general distributions of dividend growth in a Lucas economy with multiple "trees," idiosyncratic volatility will affect expected returns in ways that are not captured by the log linear approximation. We derive an exact expression for the risk premia for general distributions. Assuming growth rates are Normal Inverse Gaussian (NIG) and fitting the distribution to the data used in Mehra and Prescott (1985), the coefficient of relative risk aversion required to match the equity premium is more than halved compared to the finding in their article.
|Date of creation:||30 Sep 2011|
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- Ian Martin, 2013.
"The Lucas Orchard,"
Econometric Society, vol. 81(1), pages 55-111, 01.
- Ian Martin, 2010.
"Consumption-Based Asset Pricing with Higher Cumulants,"
NBER Working Papers
16153, National Bureau of Economic Research, Inc.
- Ian W. Martin, 2013. "Consumption-Based Asset Pricing with Higher Cumulants," Review of Economic Studies, Oxford University Press, vol. 80(2), pages 745-773.
- Mahmoud Hamada & Emiliano A. Valdez, 2008. "CAPM and Option Pricing With Elliptically Contoured Distributions," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 75(2), pages 387-409.
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