Incentive and Welfare Effects of Idiosyncratic Return Risk

34 Pages Posted: 29 Mar 2018 Last revised: 23 Mar 2020

See all articles by Christophe Courbage

Christophe Courbage

Haute Ecole de Gestion de Genève - University of Applied Sciences Western Switzerland (HES-SO)

Richard Peter

University of Iowa

Béatrice Rey

University of Lyon 2 - Groupe d'Analyse et de Théorie Economique (GATE)

Date Written: March 19, 2020

Abstract

We provide a microeconomic analysis of the incentive and welfare effects of idiosyncratic return risk. While most of the existing literature has focused on risky returns as an aggregate shock, we allow for correlation between returns and the agent's non-financial endowment. Using a simple consumption-saving model with two periods, time-separable utility, and two states of nature allows us to rewrite the idiosyncratic return with the help of a transfer rate that measures the spread between the return in the good and the bad state of nature. At the extensive margin, a critical level of the transfer rate separates savers from borrowers. At the intensive margin, we identify restrictions on the agent's risk preferences for a larger transfer rate to raise saving. Furthermore, we analyze the welfare effects of idiosyncratic returns by characterizing the transfer rate that maximizes an individual's intertemporal expected utility. The welfare benefits of idiosyncratic returns derive from their insurance effects.

Keywords: correlation attitude, risk preferences, saving, idiosyncratic returns

JEL Classification: D14, D15, D60, D81, E21, E43

Suggested Citation

Courbage, Christophe and Peter, Richard and Rey, Béatrice, Incentive and Welfare Effects of Idiosyncratic Return Risk (March 19, 2020). Available at SSRN: https://ssrn.com/abstract=3152399 or http://dx.doi.org/10.2139/ssrn.3152399

Christophe Courbage

Haute Ecole de Gestion de Genève - University of Applied Sciences Western Switzerland (HES-SO) ( email )

Geneva
Switzerland

Richard Peter (Contact Author)

University of Iowa ( email )

341 Schaeffer Hall
Iowa City, IA 52242-1097
United States

Béatrice Rey

University of Lyon 2 - Groupe d'Analyse et de Théorie Economique (GATE) ( email )

93, chemin des Mouilles
Ecully, 69130
France

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