Idiosyncratic Risk and Higher-Order Cumulants

Frederik Lundtofte () and Anders Wilhelmsson ()

No 2011:33, Working Papers from Lund University, Department of Economics

Abstract: We show that, when allowing for general distributions of dividend growth in a Lucas economy with multiple "trees," idiosyncratic volatility will affect expected returns in ways that are not captured by the log linear approximation. We derive an exact expression for the risk premia for general distributions. Assuming growth rates are Normal Inverse Gaussian (NIG) and fitting the distribution to the data used in Mehra and Prescott (1985), the coefficient of relative risk aversion required to match the equity premium is more than halved compared to the finding in their article.

Keywords: diosyncratic risk; idiosyncratic volatility; risk premia; cumulants; NIG distribution (search for similar items in EconPapers)
JEL-codes: C13 G12 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-upt
Date: 2011-09-30
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