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Background risk in consumption and the equity risk premium

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  • Andrei Semenov

    (York University)

Abstract

We consider the economy in which an agent faces, in addition to market risk, an additive independent background risk in consumption. In contrast to the Lucas (Econometrica 46:1429–1445, 1978) complete consumption insurance model, under plausible assumptions about the unconditional mean and variance of the agent’s subjective distribution of background risk the model with the additive independent background risk fits the historical average excess return on the US stock market with the coefficient of relative risk aversion (RRA) below five for the subsets of households designated as assetholders. The greater the size and/or the lower the expected value of background risk, the lower (compared to the Lucas (Econometrica 46:1429–1445, 1978) model) the value of the RRA coefficient needed for the model with background risk to match the historical average equity premium. Allowing for an extremely unlike large decrease in the agent’s consumption considerably decreases the required coefficient of RRA. It is concluded that the presence of the additive independent background risk in the consumption of assetholders can account for nearly 60 % of the historical average equity premium, hence rationalizing the equity premium puzzle of Mehra and Prescott (J Monet Econ 15:145–162, 1985). With RRA below five, the model with background risk is consistent with the historical average real interest rate if the agent has the subjective time discount factor lower than, but close to, 1. The findings are robust to the assumed type of background risk, the proxy for the market portfolio, and the threshold value in the definition of assetholders.

Suggested Citation

  • Andrei Semenov, 2017. "Background risk in consumption and the equity risk premium," Review of Quantitative Finance and Accounting, Springer, vol. 48(2), pages 407-439, February.
    • Handle: RePEc:kap:rqfnac:v:48:y:2017:i:2:d:10.1007_s11156-016-0556-2
    DOI: 10.1007/s11156-016-0556-2
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    More about this item

    Keywords

    Consumption CAPM; Equity premium puzzle; Incomplete consumption insurance; Risk aversion;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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