Asset pricing with idiosyncratic risk and overlapping generations

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Abstract
A number of existing studies have concluded that risk sharing allocations supported by competitive, incomplete markets equilibria are quantitatively close to first-best. Equilibrium asset prices in these models have been difficult to distinguish from those associated with a complete markets model, the counterfactual features of which have been widely documented. This paper asks if life cycle considerations, in conjunction with persistent idiosyncratic shocks which become more volatile during aggregate downturns, can reconcile the quantitative properties of the competitive asset pricing framework with those of observed asset returns. We begin by arguing that data from the Panel Study on Income Dynamics support the plausibility of such a shock process. Our estimates suggest a high degree of persistence as well as a substantial increase in idiosyncratic conditional volatility coincident with periods of low growth in U.S. GNP. When these factors are incorporated in a stationary overlapping generations framework, the implications for the return on risky assets are substantial, however not on the order of magnitude required to generate the average equity premium observed on the U.S. stock market. The largest Sharpe ratio our economies can support is roughly 16\%, whereas that associated with the overall sample from the \citeasnoun{Mehra-Prescott-85} data set is 37\%.

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