Asset pricing with idiosyncratic risk and overlapping generations

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.