Climbing and Falling Off the Ladder: Asset Pricing Implications of Labor Market Event Risk

Abstract

This paper proposes state-dependent, idiosyncratic tail risk as a key driver of asset prices. I provide new evidence on the importance of tail events in explaining the shape of the idiosyncratic distribution of income growth rates and its evolution over time. I then formalize its role within a tractable affine, jump-diffusion asset pricing framework with recursive preferences, heterogeneous agents and incomplete markets, making my results immediately applicable to a wide class of existing models for aggregate dynamics. Next, I demonstrate its importance using a calibrated model in which agents are exposed to a time-varying probability of experiencing a rare, idiosyncratic disaster. The model, whose parameters are disciplined by the data, matches the level and dynamics of the equity premium. Empirically, stock returns are highly informative about labor market event risk, and, consistent with the model’s predictions, initial claims for unemployment, a proxy for labor market uncertainty, is a highly robust predictor of returns.