Asset Pricing with Endogenously Uninsurable Tail Risk

Abstract: This paper studies asset pricing in a setting in which idiosyncratic risk in human capital is not fully insurable. Firms use long-term contracts to provide insurance to workers, but neither side can commit to these contracts; furthermore, worker-firm relationships have endogenous durations owing to costly and unobservable effort. Uninsured tail risk in labor earnings arises as a part of an optimal risk-sharing scheme. In the general equilibrium, exposure to the resulting tail risk generates higher risk premia, more volatile returns, and variations in expected returns across firms. Model outcomes are consistent with the cyclicality of factor shares in the aggregate, and the heterogeneity in exposures to idiosyncratic and aggregate shocks in the cross section.

Keywords: Limited commitment; Equity premium puzzle; Tail risk; Dynamic contracting;

JEL Classification: E3; G1;

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Bibliographic Information

Provider: Federal Reserve Bank of Minneapolis

Part of Series: Staff Report

Publication Date: 2018-08-22

Number: 570

Pages: 75 pages