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IDIOSYNCRATIC SHOCKS AND ASSET RETURNS IN THE REAL-BUSINESS-CYCLE MODEL: AN APPROXIMATE ANALYTICAL APPROACH

Published online by Cambridge University Press:  14 July 2005

EVA CÁRCELES-POVEDA
EVA CÁRCELES-POVEDA
Affiliation:
SUNY at Stony Brook
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Abstract

The present paper uses an analytical approach to derive approximate closed-form solutions for the asset moments of a real-business-cycle model with idiosyncratic risk. To preserve analytical tractability, risk sharing is completely shut down. Further, the firm is assumed to maximize a variant of value maximization, given that its usual objective is no longer well defined under market incompleteness. When idiosyncratic risk is incorporated into the model, the asset moments can be decomposed into their value under identical households plus a new idiosyncratic term. Under full constrained persistence, in which case the same household determines the asset moments every period, the model is able to generate the risk premium in the data with reasonable parameter values, but it cannot generate the risk return trade-off. While the quantitative impact of idiosyncratic risk is smaller when there is only some persistence in who is constrained, the qualitative predictions are unaltered.

Keywords

Asset PricesIncomplete MarketsRBC ModelAnalytical Solution
Type
ARTICLES
Information
Macroeconomic Dynamics , Volume 9 , Issue 3 , June 2005 , pp. 295 - 320
Copyright
© 2005 Cambridge University Press

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