Private equity premium in a general equilibrium model of uninsurable investment risk

Abstract

This paper studies the quantitative properties of a general equilibrium model where a continuum of heterogeneous entrepreneurs are subject to aggregate as well as idiosyncratic risks in the presence of a borrowing constraint. The calibrated model matches the highly skewed wealth and income distributions of entrepreneurs. The authors provide an accurate solution to the model despite the significant nonlinearities that are absent in the economy with uninsurable labor income risk. The model is capable of generating the average private equity premium of roughly 3 percent and a low risk-free rate. The model also produces procyclicality of the risk-free rate and countercyclicality of the average private equity premium. The countercyclicality of the average equity premium is largely driven by tightening (loosening) of financing constraints during recessions (booms).Risk ; Private equity ; Business cycles