Asset Pricing in OLG Economies With Borrowing Constraints and Idiosyncratic Income Risk

53 Pages Posted: 28 Sep 2018

See all articles by Daniel Harenberg

Daniel Harenberg

ETH Zürich - CER-ETH - Center of Economic Research at ETH Zurich

Date Written: September 17, 2018

Abstract

This paper analyzes how the combination of borrowing constraints and idiosyncratic risk affects the equity premium in an overlapping generations economy. I find that introducing a zero-borrowing constraint in an economy without idiosyncratic risk increases the equity premium by 70 percent, which means that the mechanism described in Constantinides, Donaldson, and Mehra (2002) is dampened because of the large number of generations and production. With social security the effect of the zero-borrowing constraint is a lot weaker. More surprisingly, when I introduce idiosyncratic labor income risk in an economy without a zero-borrowing constraint, the equity premium increases by 50 percent, even though the income shocks are independent of aggregate risk and are not permanent. The reason is that idiosyncratic risk makes the endogenous natural borrowing limits much tighter, so that they have a similar effect to an exogenously imposed zero-borrowing constraint. This intuition is confirmed when I add idiosyncratic risk in an economy with a zero-borrowing constraint: neither the equity premium nor the Sharpe ratio change, because the zero-borrowing constraint is already tighter than the natural borrowing limits that result when idiosyncratic risk is added.

Keywords: equity premium; idiosyncratic risk; aggregate risk; lifecycle

JEL Classification: G12; D91

Suggested Citation

Harenberg, Daniel, Asset Pricing in OLG Economies With Borrowing Constraints and Idiosyncratic Income Risk (September 17, 2018). SAFE Working Paper No. 229. Available at SSRN: https://ssrn.com/abstract=3252443 or http://dx.doi.org/10.2139/ssrn.3252443

Daniel Harenberg (Contact Author)

ETH Zürich - CER-ETH - Center of Economic Research at ETH Zurich ( email )

Zürichbergstrasse 18
Zurich, 8092
Switzerland

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