Discussion: Can Heterogeneity, Undiversified Risk, and Trading Frictions Solve the Equity Premium Puzzle?
1. INTRODUCTION
Heaton and Lucas’ chapter reviews the role background risk plays for the equity premium. With background risk we understand risk idiosyncratic to the agent, such as labor income risk or entrepreneurial risk. Why are we obsessed with the role of background risk for explaining the equity premium? The obvious first answer is that it might work: individual consumption growth is orders of magnitude more volatile than aggregate consumption growth.
But there is also a broader motivation. The study of heterogeneity in macroeconomics aims at explaining the evolution of the joint distribution ...
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