Asset Pricing with Idiosyncratic Risk and Overlapping Generations

53 Pages Posted: 6 Dec 2001

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: November 2001

Abstract

Constantines and Duffie (1996) show that for Idiosyncratic 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 that incorporate macroeconomic information going beyond the time horizon of the PSID, dating back to 1910. We go on to argue that life-cycle 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 US stock market.

Keywords: PSID, life-cycle effects

JEL Classification: D91, G12, J30

Suggested Citation

Storesletten, Kjetil and Telmer, Christopher I. and Yaron, Amir, Asset Pricing with Idiosyncratic Risk and Overlapping Generations (November 2001). CEPR Discussion Paper No. 3065, Available at SSRN: https://ssrn.com/abstract=292881

Kjetil Storesletten (Contact Author)

University of Oslo - Department of Economics ( email )

P.O. Box 1095 Blindern
N-0317 Oslo
Norway
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HOME PAGE: http://folk.uio.no/kjstore/

Centre for Economic Policy Research (CEPR)

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United Kingdom

Christopher I. Telmer

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

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(412) 268-6837 (Fax)

Amir Yaron

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

The Wharton School
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Philadelphia, PA 19104
United States
215-898-1241 (Phone)
215-898-6200 (Fax)

National Bureau of Economic Research (NBER) ( email )

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Cambridge, MA 02138
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