Asset Prices in a Production Economy with Long-run and Idiosyncratic Risk

Ivan Sutóris

Working Papers from Czech National Bank, Research and Statistics Department

Abstract: This paper studies risk premia in an incomplete-markets economy with households facing idiosyncratic consumption risk. If the dispersion of idiosyncratic risk varies over the business cycle and households have a preference for early resolution of uncertainty, asset prices will be affected not only by news about current and expected future aggregate consumption (as in models with a representative agent), but also by news about current and future changes in the cross-sectional distribution of individual consumption. I investigate whether this additional effect can help explain high risk premia in a production economy where the aggregate consumption process is endogenous and thus can potentially be affected by the presence of idiosyncratic risk. Analyzing a neoclassical growth model combined with Epstein-Zin preferences and a tractable form of household heterogeneity, I find that countercyclical idiosyncratic risk increases the risk premium, but also effectively lowers the willingness of households to engage in intertemporal substitution and thus changes the dynamics of aggregate consumption. Nevertheless, with the added flexibility of Epstein-Zin preferences, it is possible both to increase risk premia and to maintain the same dynamics of quantities if we allow for higher intertemporal elasticity of substitution at the individual level.

Keywords: Idiosyncratic risk; incomplete markets; production economy; risk premium (search for similar items in EconPapers)
JEL-codes: E13 E21 E44 G12 (search for similar items in EconPapers)
Date: 2018-05
New Economics Papers: this item is included in nep-dge and nep-mac
References: Add references at CitEc
Citations:

Downloads: (external link)
https://www.cnb.cz/export/sites/cnb/en/economic-re ... wp/cnbwp_2018_04.pdf

Related works:
Working Paper: Asset Prices in a Production Economy with Long Run and Idiosyncratic Risk (2018)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:cnb:wpaper:2018/4

Access Statistics for this paper

More papers in Working Papers from Czech National Bank, Research and Statistics Department Contact information at EDIRC.
Bibliographic data for series maintained by Tomas Karhanek (tomas.karhanek@cnb.cz).