Climbing and falling off the ladder: Asset pricing implications of labor market event risk
Households face countercyclical tail risks in labor earnings. Rare but severe income drops spike in downturns. These disasters alone explain the high persistent equity premium once modeled heterogeneous agents. The paper defines labor market event risk to formalize sudden earnings shocks. It shows stock returns carry vital signals about labor risk and unemployment claims predict future returns. Calibrated on administrative data, the model matches equity premium dynamics. Questions remain on calibration bias and external robustness.
What it examines
This paper examines how rare, individual job‐loss risks, which rise when the economy weakens, shape asset prices. Using an asset pricing model with recursive preferences, varied agents, and incomplete markets, the author calibrates a disaster probability to match the equity premium and links job‐loss risk to stock returns.
What it concludes
Results show that time‐varying labor‐market tail risks help explain the high equity premium and that stock returns reliably signal labor uncertainty. Initial unemployment claims robustly predict returns. The findings can inform risk management, return forecasting, and policy design. Future work could explore other labor events and deeper heterogeneity.
Evidence objects
Households face large countercyclical idiosyncratic tail risks; rare severe income drops during downturns; these alone explain the high, persistent equity premium in robust models with recursive preferences and incomplete markets.
key_findings bullet 1 · key_findings · validation V0
Major contribution Schmidt integrates time-varying probabilities of individual earnings disasters into an asset pricing model, showing stock returns inform on labor risk and that unemployment initial claims predict future returns.
key_findings bullet 2 · key_findings · validation V0
Introduces labor market event risk, a definition for sudden rare earnings shocks bridging labor economics and finance; calibrated against administrative data to match equity premium dynamics, relying on calibration assumptions.
key_findings bullet 3 · key_findings · validation V0
This paper pioneers linking time-varying idiosyncratic labor-market tail risks with equity premiums using a heterogeneous-agent asset pricing framework. It offers novel quantitative calibration to administrative earnings data and empirically ties evolving labor disasters to unemployment claims. By extending rare-disaster literature, its fresh perspective deepens predictive equity research with empirical relevance.
key_findings bullet 4 · key_findings · validation V0
Raw abstract and provenance
Administrative earnings data reveal that households are exposed to large, countercyclical idiosyncratic tail risks in labor earnings. I illustrate how these risks affect asset prices within an asset pricing framework with recursive preferences, heterogeneous agents and incomplete markets. Quantitatively, a model in which agents face a time-varying probability of experiencing a rare, idiosyncratic disaster, with parameters disciplined by data, matches the level and dynamics of the equity premium. Stock returns are highly informative about labor market event risk, and, consistent with model predictions, initial claims for unemployment, a proxy for labor market uncertainty, is a highly robust predictor of returns.
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