Working Paper: CEPR ID: DP5936
Authors: Dirk Krueger; Hanno Lustig
Abstract: In models with a large number of agents who have constant relative risk aversion (CRRA) preferences, the absence of insurance markets for idiosyncratic labour income risk has no effect on the premium for aggregate risk if the distribution of idiosyncratic risk is independent of aggregate shocks. In spite of the missing markets, a representative agent who consumes aggregate income prices the excess returns on stocks correctly. This result holds regardless of the persistence of idiosyncratic shocks, as long as they are not permanent, even when households face binding, and potentially very tight borrowing constraints. Consequently, in this class of models there is no link between the extent of self-insurance against idiosyncratic income risk and aggregate risk premia.
Keywords: idiosyncratic income risk; incomplete markets; risk premium
JEL Codes: G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| absence of insurance markets for idiosyncratic labor income risk (G52) | does not affect the premium for aggregate risk (G22) |
| distribution of idiosyncratic risk is independent of aggregate shocks (D39) | absence of insurance markets for idiosyncratic labor income risk does not affect the premium for aggregate risk (G52) |
| absence of insurance markets for idiosyncratic labor income risk (G52) | does not increase the risk premium that stocks command over bonds (G12) |
| market incompleteness (D52) | does not influence aggregate risk premia (G40) |
| independence of idiosyncratic and aggregate shocks (E19) | pricing of risk (G19) |
| adding markets (D40) | does not necessarily lead to more risk-sharing (G59) |
| self-insurance against idiosyncratic income risk (G52) | irrelevant for the pricing of aggregate risk (G19) |