Working Paper: NBER ID: w12634
Authors: Dirk Krueger; Hanno Lustig
Abstract: In a standard incomplete markets model with a continuum of households that have constant relative risk aversion (CRRA) preferences, the absence of insurance markets for idiosyncratic labor income risk has no effect on the premium for aggregate risk if the distribution of idiosyncratic risk is independent of aggregate shocks and aggregate consumption growth is independent over time. In the equilibrium, which features trade and binding solvency constraints, as opposed to Constantinides and Duffie (1996), households only use the stock market to smooth consumption; the bond market is inoperative. Furthermore we show that the cross-sectional wealth and consumption distributions are not affected by aggregate shocks. These results hold regardless of the persistence of idiosyncratic shocks, and arise even when households face tight solvency constraints, but only a weaker irrelevance result survives when we allow for predictability in aggregate consumption growth.
Keywords: Market Incompleteness; Aggregate Risk; Idiosyncratic Risk; Asset Pricing; Risk Premium
JEL Codes: E21; E44; G0
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) |
| uninsurable idiosyncratic risk (G22) | lowers the equilibrium risk-free rate (E43) |
| history of aggregate shocks (N10) | does not impact equilibrium allocations and prices (D51) |
| extent of households' ability to insure against idiosyncratic income risk (G52) | does not affect risk premia (G19) |
| tightness of borrowing constraints (F65) | does not affect risk premia (G19) |
| independence of idiosyncratic risk distribution from aggregate shocks (D39) | does not affect the premium for aggregate risk (G22) |
| cross-sectional wealth and consumption distributions (E21) | not influenced by aggregate shocks (E19) |