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Institute for International Economic Studies, Stockholm University Seminar Papers, Institute for International Economic Studies, Stockholm University

No 703:
Asset pricing with idiosyncratic risk and overlapping generations

Kjetil Storesletten (), Chris Telmer () and Amir Yaron ()

Abstract: Constantinides and Duffie (1996) show that for idiosynratic 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 which incorporate macroeconomic information going beyond the time horizon of the PSID, dating back to 1910. We go on to argue that life-cycles 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 U.S. stock market.

Keywords: asset pricing; idiosyncratic risk; overlapping generations; (follow links to similar papers)

JEL-Codes: D31; E21; (follow links to similar papers)

56 pages, February 12, 2002

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