Staff Reports

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

May 2001Number 130
JEL classification: E44, G11, G12

Author: Martin Lettau

This paper uses Hansen and Jagannathan's (1991) volatility bounds to evaluate models with idiosyncratic consumption risk. I show that idiosyncratic risk does not change the volatility bounds at all when consumers have CRRA preferences and the distribution of the idiosyncratic shock is independent of the aggregate state. Following Mankiw (1986), I then 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 are not reliable, I compute an upper bound of the volatility bounds using individual income data and assume that agents have to consume their endowment. I find that the model does not pass the Hansen and Jagannathan test even for very volatile idiosyncratic income data.

Available only in PDFPDF30 pages / 266 kb

For a published version of this report, see Martin Lettau, "Idiosyncratic Risk and Volatility Bounds, or Can Models with Idiosyncratic Risk Solve the Equity Premium Puzzle?" Review of Economics and Statistics84, no. 2 (May 2002): 376-80.