Incentive and Welfare Effects of Idiosyncratic Return Risk

We provide a microeconomic analysis of the incentive and welfare effects of idiosyncratic return risk. While most of the existing literature has focused on risky returns as an aggregate shock, we allow for correlation between returns and the agent's non-financial endowment. Using a simple consumption-saving model with two periods, time-separable utility, and two states of nature allows us to rewrite the idiosyncratic return with the help of a transfer rate that measures the spread between the return in the good and the bad state of nature. At the extensive margin, a critical level of the transfer rate separates savers from borrowers. At the intensive margin, we identify restrictions on the agent's risk preferences for a larger transfer rate to raise saving. Furthermore, we analyze the welfare effects of idiosyncratic returns by characterizing the transfer rate that maximizes an individual's intertemporal expected utility. The welfare benefits of idiosyncratic returns derive from their insurance effects