Asset Pricing With Idiosyncratic Risk and Overlapping Generations

What is the effect of non-tradeable idiosyncratic risk on asset-market risk premiums? Constantinides and Duffie [Constantinides, G.M., Duffie, D., 1996. Asset pricing with heterogeneous consumers. Journal of Political Economy 104, 219–240] and Mankiw [Mankiw, N.G., 1986. The equity premium and the concentration of aggregate shocks. Journal of Financial Economics 17, 211–219] have shown that risk premiums will increase if the idiosyncratic shocks become more volatile during economic contractions. We add two important ingredients to this relationship: (i) the life cycle, and (ii) capital accumulation. We show that in a realistically-calibrated life-cycle economy with production these ingredients mitigate the ability of idiosyncratic risk to account for the observed Sharpe ratio on US equity. While the Constantinides–Duffie model can account for the US value of 41% with a risk-aversion coefficient of 8, our model generates a Sharpe ratio of 33%, which is roughly half-way to the complete-markets value of 25%. Almost all of this reduction is due to capital accumulation. Life-cycle effects are important in our model—we demonstrate that idiosyncratic risk matters for asset pricing because it inhibits the intergenerational sharing of aggregate risk—but their net effect on the Sharpe ratio is small

Consumption and Risk Sharing Over the Life Cycle

A striking feature of U.S. data on income and consumption is that inequality increases with age. This paper asks if individual-specific earnings risk can provide a coherent explanation. We find that it can. We construct an overlapping generations general equilibrium model in which households face uninsurable earnings shocks over the course of their lifetimes. Earnings inequality is exogenous and is calibrated to match data from the U.S. Panel Study on Income Dynamics. Consumption inequality is endogenous and matches well data from the U.S. Consumer Expenditure Survey. The total risk households face is decomposed into that realized before entering the labor market and that realized throughout the working years. In welfare terms, the latter is found to be more important than the former

Current Account Fact and Fiction

With US trade and current account deficits approaching 6% of GDP, some have argued that the country is "on the comfortable path to ruin" and that the required "adjustment'' may be painful. We suggest instead that things are fine: although national saving is low, the ratios of household and consolidated net worth to GDP remain high. In our view, the most striking features of the world at present are the low rates of investment and growth in some of the richest countries, whose surpluses account for about half of the US deficit. The result is that financial capital is flowing out of countries with low investment and growth and into the US and other fast-growing countries. Oil exporters account for much of the rest.

Monetary Policy and the Uncovered Interest Parity Puzzle

High interest rate currencies tend to appreciate. This is the uncovered interest rate parity (UIP) puzzle. It is primarily a statement about short-term interest rates and how they are related to exchange rates. Short-term interest rates are strongly affected by monetary policy. The UIP puzzle, therefore, can be restated in terms of monetary policy. Do foreign and domestic monetary policies imply exchange rates that violate UIP? We represent monetary policy as foreign and domestic Taylor rules. Foreign and domestic pricing kernels determine the relationship between these Taylor rules and exchange rates. We examine different specifications for the Taylor rule and ask which can resolve the UIP puzzle. We find evidence in favor of a particular asymmetry. If the foreign Taylor rule responds to exchange rate variation but the domestic Taylor rule does not, the model performs better. A calibrated version of our model is consistent with many empirical observations on real and nominal exchange rates, including Fama's negative correlation between interest rate differentials and currency depreciation rates.

provided that full credit, including © notice, is given to the source. Monetary Policy and the Uncovered Interest Parity Puzzle

Hollifield for many helpful comments and discussions. Telmer is grateful to CREI, Universitat Pompeu Fabra, for generous hospitality while some of this work was completed. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research