Working Paper: CEPR ID: DP3065
Authors: Kjetil Storesletten; Chris Telmer; Amir Yaron
Abstract: Constantines and Duffie (1996) show that for Idiosyncratic risk to matter for asset pricing the shocks must (i) be highly persistent and (ii) become more volatile during economic contractions. We show that data from the Panel Study on Income Dynamics (PSID) are consistent with these requirements. Our results are based on econometric methods that incorporate macroeconomic information going beyond the time horizon of the PSID, dating back to 1910. We go on to argue that life-cycle effects are fundamental for how idiosyncratic risk affects asset pricing. We use a stationary overlapping-generations model to show that life-cycle effects can either mitigate or accentuate the equity premium, the critical ingredient being whether agents accumulate or deccumulate risky assets as they age. Our model predicts the latter and is able to account for both the average equity premium and the Sharpe ratio observed on the US stock market.
Keywords: equity premium; lifecycle effects; heteroskedasticity; microeconomic uncertainty; PSID
JEL Codes: D91; G12; J30
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| idiosyncratic risk (D81) | asset pricing (G19) |
| persistence of economic shocks (E32) | asset pricing (G19) |
| volatility of economic shocks (E32) | asset pricing (G19) |
| lifecycle effects (C41) | asset pricing (G19) |
| lifecycle effects (C41) | equity premium (G12) |
| asset accumulation behavior (D14) | equity premium (G12) |
| de-accumulation of risky assets (G19) | equity premium (G12) |