Idiosyncratic Income Risk, Precautionary Saving, and Asset Prices

Abstract

Households are subject to substantial tail risk in individual labor income, and the amount of income risk fluctuates over the business cycle. This paper proposes a New Keynesian production-based asset pricing model where idiosyncratic labor income risk is a key source of priced risk in equity markets. Uninsured income tail risk drives the aggregate demand for consumption goods through a time-varying precautionary saving motive, generating cyclicality in firm cash flows. In the cross section, firms facing more elastic demand are more exposed to fluctuations in idiosyncratic tail risk. This risk exposure is compensated by a significant and countercyclical risk premium in equity returns. Empirical findings support the predictions of the model.

JEL Classification: G12,E12,E24,E44