Working Paper: CEPR ID: DP1795
Authors: Martin Lettau
Abstract: This paper evaluates models with idiosyncratic consumption risk using Hansen and Jagannathan?s (1991) volatility bounds. It is shown that idiosyncratic risk does not change the volatility bounds at all when consumers have constant relative risk aversion (CRRA) preferences and the distribution of the idiosyncratic shock is independent of the aggregate state. Following Mankiw (1986), I show that idiosyncratic risk can help to enter the bounds when idiosyncratic uncertainty depends on the aggregate state of the economy. Since individual consumption data is not reliable, I compute an upper bound of the volatility bounds using individual income data and assume that agents must consume their endowment. I find that the model does not pass the Hansen and Jagannathan test even for very volatile idiosyncratic income data.
Keywords: idiosyncratic risk; risk premia; volatility bounds; asset prices
JEL Codes: E44; G11; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Idiosyncratic consumption risk (D11) | HJ bounds (C61) |
| Covariance of idiosyncratic shock and aggregate state (D89) | Increase in risk premia (G19) |
| Idiosyncratic shocks (D89) | Asset prices (G19) |
| Idiosyncratic consumption risk (D11) | Equity premium puzzle (G19) |