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Asset Pricing with Endogenously Uninsurable Tail Risk

Staff Report 570 | Published April 13, 2020

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Authors

Hengjie Ai University of Minnesota

Asset Pricing with Endogenously Uninsurable Tail Risk

Abstract

This paper studies asset pricing and labor market dynamics 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 fully commit; furthermore, owing to costly and unobservable retention effort, worker-firm relationships have endogenous durations. Uninsured tail risk in labor earnings arises as a part of an optimal risk-sharing scheme. In equilibrium, exposure to the tail risk generates higher aggregate risk premia and higher return volatility. Consistent with data, firm-level labor share predicts both future returns and pass-throughs of firm-level shocks to labor compensation.