Asset Pricing with idiosyncratic income risk

• Applicant: Professor Dr. Joachim Grammig
• Subject Area: Statistics and Econometrics ; Accounting and Finance
• Term: from 2013 to 2015
• Project identifier: Deutsche Forschungsgemeinschaft (DFG) - Project number 234800321

The turmoil of the financial crisis provokes the question whether price processes in modern financial markets evolve independently of real economic processes and rather arise from irrational exuberance. This question emphasizes the importance of theoretical and empirical work that links financial price processes to the real economy. We place our research proposal in this context. In particular, we intend to investigate the role of idiosyncratic income risk in asset pricing. We are not the first to address this issue, but extant studies suffer from substantial weaknesses: The micro-data on consumption used in previous empirical work are notoriously prone to measurement errors, the assumptions about the individual income processes do not match empirical facts observed in individual income data, and the impact of rare but disastrous income changes is neglected. In Constantinides and Duffie's (1996) base model it is only the cross-sectional variance of income changes which has asset pricing implications. We deal with these weaknesses by developing a coherent measure of idiosyncratic income risk, and by generalizing the income process to allow for rare but severe idiosyncratic shocks. Our empirical analyses will be based on data which are less prone to measurement errors.

• DFG Programme: Research Grants