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Idiosyncratic Risk and Higher-Order Cumulants

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Abstract

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.

Suggested Citation

  • Lundtofte, Frederik & Wilhelmsson, Anders, 2011. "Idiosyncratic Risk and Higher-Order Cumulants," Working Papers 2011:33, Lund University, Department of Economics.
  • Handle: RePEc:hhs:lunewp:2011_033
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    File URL: http://project.nek.lu.se/publications/workpap/papers/WP11_33.pdf
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    References listed on IDEAS

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    1. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    2. Ian Martin, 2013. "The Lucas Orchard," Econometrica, Econometric Society, vol. 81(1), pages 55-111, January.
    3. 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.
    4. Ian W. Martin, 2013. "Consumption-Based Asset Pricing with Higher Cumulants," Review of Economic Studies, Oxford University Press, vol. 80(2), pages 745-773.
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    Keywords

    diosyncratic risk; idiosyncratic volatility; risk premia; cumulants; NIG distribution;

    JEL classification:

    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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