Asset Pricing with Idiosyncratic Risk and Overlapping Generations

Universitat Pompeu Fabra Working Paper No. 405

63 Pages Posted: 19 Apr 2000

See all articles by Kjetil Storesletten

Kjetil Storesletten

University of Oslo - Department of Economics; Centre for Economic Policy Research (CEPR)

Chris Telmer

Carnegie Mellon University - David A. Tepper School of Business

Amir Yaron

University of Pennsylvania -- Wharton School of Business; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: July 1999

Abstract

A number of existing studies have concluded that risk sharing allocations supported by competitive, incomplete markets equilibria are quantitatively close to first-best. Equilibrium asset prices in these models have been difficult to distinguish from those associated with a complete markets model, the counterfactual features of which have been widely documented. This paper asks if life cycle considerations, in conjunction with persistent idiosyncratic shocks which become more volatile during aggregate downturns, can reconcile the quantitative properties of the competitive asset pricing framework with those of observed asset returns. We begin by arguing that data from the Panel Study on Income Dynamics support the plausibility of such a shock process. Our estimates suggest a high degree of persistence as well as a substantial increase in idiosyncratic conditional volatility coincident with periods of low growth in U.S. GNP. When these factors are incorporated in a stationary overlapping generations framework, the implications for the returns on risky assets are substantial. Plausible parameterizations of our economy are able to generate Sharpe ratios which match those observed in U.S. data. Our economy cannot, however, account for the level of variability of stock returns, owing in large part to the specification of its production technology.

JEL Classification: G12, E44

Suggested Citation

Storesletten, Kjetil and Telmer, Christopher I. and Yaron, Amir, Asset Pricing with Idiosyncratic Risk and Overlapping Generations (July 1999). Universitat Pompeu Fabra Working Paper No. 405, Available at SSRN: https://ssrn.com/abstract=199058 or http://dx.doi.org/10.2139/ssrn.199058

Kjetil Storesletten (Contact Author)

University of Oslo - Department of Economics ( email )

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Centre for Economic Policy Research (CEPR)

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Christopher I. Telmer

Carnegie Mellon University - David A. Tepper School of Business ( email )

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Amir Yaron

University of Pennsylvania -- Wharton School of Business ( email )

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National Bureau of Economic Research (NBER) ( email )

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