Asset Prices and Intergenerational Risk Sharing: the Role of Idiosyncratic Earnings Shocks
Rajnish Mehra (ed.), Handbooks in Finance; Handbook of the Equity Risk Premium (pages 565-590). Amsterdam: Elsevier
In their seminal paper, Mehra and Prescott (1985), Rajnish Mehra and Edward Prescott were the first among many subsequent authors to suggest that non-traded labor-market risk may provide a resolution to the equity-premium puzzle. The most direct demonstration of this was Constantinides and Duffie (1996), who showed that, under certain conditions, cross-sectionally uncorrelated unit-root shocks which become more volatile during economic contractions can resolve the puzzle. We examine the robustness of this to life-cycle effects. Retired people, for instance, do not face labor-market risk. If we incorporate them, to what extent will the equity premium be resurrected? Our answer is "not very much." Our model, with realistic life cycle features, can still account for about 75% of the average equity premium and the Sharpe ratio observed on the U.S. stock market.