DP1795 Idiosyncratic Risk and Volatility Bounds, or, Can Models with Idiosyncratic Risk Solve the Equity Premium Puzzle?

Author(s): Martin Lettau
Publication Date: January 1998
Keyword(s): Asset Prices, idiosyncratic risk, Risk Premia, volatility bounds
JEL(s): E44, G11, G12
Programme Areas: International Macroeconomics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=1795

This paper evaluates models with idiosyncratic consumption risk using Hansen and Jagannathan?s (1991) volatility bounds. It is shown that idiosyncratic risk does not change the volatility bounds at all when consumers have constant relative risk aversion (CRRA) preferences and the distribution of the idiosyncratic shock is independent of the aggregate state. Following Mankiw (1986), I show that idiosyncratic risk can help to enter the bounds when idiosyncratic uncertainty depends on the aggregate state of the economy. Since individual consumption data is not reliable, I compute an upper bound of the volatility bounds using individual income data and assume that agents must consume their endowment. I find that the model does not pass the Hansen and Jagannathan test even for very volatile idiosyncratic income data.