Asset pricing with idiosyncratic risk and overlapping generations

Kjetil Storesletten, Christopher I. Telmer, Amir Yaron

Research output: Contribution to journalArticlepeer-review

105 Scopus citations

Abstract

What is the effect of non-tradeable idiosyncratic risk on asset-market risk premiums? Constantinides and Duffie [Constantinides, G.M., Duffie, D., 1996. Asset pricing with heterogeneous consumers. Journal of Political Economy 104, 219-240] and Mankiw [Mankiw, N.G., 1986. The equity premium and the concentration of aggregate shocks. Journal of Financial Economics 17, 211-219] have shown that risk premiums will increase if the idiosyncratic shocks become more volatile during economic contractions. We add two important ingredients to this relationship: (i) the life cycle, and (ii) capital accumulation. We show that in a realistically-calibrated life-cycle economy with production these ingredients mitigate the ability of idiosyncratic risk to account for the observed Sharpe ratio on US equity. While the Constantinides-Duffie model can account for the US value of 41% with a risk-aversion coefficient of 8, our model generates a Sharpe ratio of 33%, which is roughly half-way to the complete-markets value of 25%. Almost all of this reduction is due to capital accumulation. Life-cycle effects are important in our model-we demonstrate that idiosyncratic risk matters for asset pricing because it inhibits the intergenerational sharing of aggregate risk-but their net effect on the Sharpe ratio is small.

Original languageEnglish (US)
Pages (from-to)519-548
Number of pages30
JournalReview of Economic Dynamics
Volume10
Issue number4
DOIs
StatePublished - Oct 2007
Externally publishedYes

Bibliographical note

Funding Information:
In addition to numerous participants at seminars and conferences, we thank Dave Backus, Geert Bekaert, David Bowman, Martin Browning, John Cochrane, Wouter den Haan, Mick De-vereux, Ron Gallant, René Garcia, Rick Green, John Heaton, Burton Hollifield, Mark Huggett, Narayana Kocherlakota, Per Krusell, Deborah Lucas, Pierre Mella-Barral, Bob Miller, Michael Parkin, Monika Piazzesi, Victor Ríos-Rull, Amlan Roy, Tony Smith, Paul Willen, Steve Zeldes and Stan Zin for helpful comments and suggestions. We have benefited from the support of NSF grant SES-9987602 and the Rodney White Center at Wharton. Valuable research assistance was provided by Xiaorong Dong.

Keywords

  • Asset pricing
  • Idiosyncratic risk
  • OLG

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