Discussion of Heaton and Lucas’ “Can heterogeneity, undiversified risk, and trading frictions solve the equity premium puzzle?"
Rajnish Mehra (ed.), Handbooks in Finance; Handbook of the Equity Risk Premium (pages 555-564). Amsterdam: Elsevier
Heaton and Lucas’ chapter reviews the role background risk plays for the equity
premium. With background risk we understand risk idiosyncratic to the agent, such
as labor income risk or entrepreneurial risk. Why are we obsessed with the role of
background risk for explaining the equity premium? The obvious first answer is that
it might work: individual consumption growth is orders of magnitude more volatile
than aggregate consumption growth.
But there is also a broader motivation. The study of heterogeneity in
macroeconomics aims at explaining the evolution of the joint distribution of
consumption, earnings, and wealth. The promise of this line of research is to
provide tools to evaluate government policies and to deepen our understanding of
inequality. To this end, macroeconomic facts such as the evolution of consumption
inequality represent useful restrictions of microeconomic theories – any micro theory
of inequality and markets should be consistent with these macro facts (see e.g.
Krueger and Perri (2006) and Storesletten, Telmer and Yaron (2004a) for examples
of such approach). Risk and individuals’ attitudes towards risk are at the heart of
these theories, and the equity premium puzzle – the inability of reasonably
calibrated consumption-based asset-pricing model to explain the premium –
represents a major road block for this literature.
In their chapter, Heaton and Lucas analyze labor income risk, transaction costs (in
connection with background risk), entrepreneurial risk and the role of limited stock
market participation, and I will now review their findings.