Private Equity Premium in a General Equilibrium Model of Uninsurable Investment Risk

FRB of Philadelphia Working Paper No. 11-18

Supersedes Working Paper 07-30

33 Pages Posted: 18 May 2011

See all articles by Francisco Covas

Francisco Covas

Board of Governors of the Federal Reserve System

Shigeru Fujita

Federal Reserve Bank of Philadelphia

Date Written: May 2011

Abstract

This paper studies the quantitative properties of a general equilibrium model where a continuum of heterogeneous entrepreneurs are subject to aggregate as well as idiosyncratic risks in the presence of a borrowing constraint. The calibrated model matches the highly skewed wealth and income distributions of entrepreneurs. The authors provide an accurate solution to the model despite the significant nonlinearities that are absent in the economy with uninsurable labor income risk. The model is capable of generating the average private equity premium of roughly 3 percent and a low risk-free rate. The model also produces procyclicality of the risk-free rate and countercyclicality of the average private equity premium. The countercyclicality of the average equity premium is largely driven by tightening (loosening) of financing constraints during recessions (booms).

Keywords: Uninsurable investment risk, aggregate uncertainty, private equity premium

JEL Classification: E22, G11, M13

Suggested Citation

Covas, Francisco and Fujita, Shigeru, Private Equity Premium in a General Equilibrium Model of Uninsurable Investment Risk (May 2011). Supersedes Working Paper 07-30. Available at SSRN: https://ssrn.com/abstract=1837438 or http://dx.doi.org/10.2139/ssrn.1837438

Francisco Covas (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Shigeru Fujita

Federal Reserve Bank of Philadelphia ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

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