Scandinavian Working Papers in Economics

Working Papers,
Lund University, Department of Economics

No 2011:33: Idiosyncratic Risk and Higher-Order Cumulants

Frederik Lundtofte () and Anders Wilhelmsson ()
Additional contact information
Frederik Lundtofte: Department of Economics, Lund University, Postal: Department of Economics, School of Economics and Management, Lund University, Box 7082, S-220 07 Lund, Sweden
Anders Wilhelmsson: Department of Business Administration, Lund University, Postal: Department of Business Administration, School of Economics and Management, Lund University, Box 7080, S-220 07 Lund, Sweden

Abstract: We show that, when allowing for general distributions of dividend growth in a Lucas economy with multiple "trees," idiosyncratic volatility will affect expected returns in ways that are not captured by the log linear approximation. We derive an exact expression for the risk premia for general distributions. Assuming growth rates are Normal Inverse Gaussian (NIG) and fitting the distribution to the data used in Mehra and Prescott (1985), the coefficient of relative risk aversion required to match the equity premium is more than halved compared to the finding in their article.

Keywords: diosyncratic risk; idiosyncratic volatility; risk premia; cumulants; NIG distribution

JEL-codes: C13; G12

20 pages, September 30, 2011

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WP11_33.pdf PDF-file 

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