We investigate portfolio allocations and asset returns within a stochastic OLG economy with risky equity, generation-wide labor income shocks and portfolio nonnegativity constraints. Our model assumes a difference stationary endowment process, a young generation that faces labor income uncertainty and a positive correlation between the wage risk of the young and middle generations. The model is unable to match the level of the risk-free rate or the volatility of equity returns. We encounter the risk-free rate puzzle when the cross-sectional distribution of labor income is calibrated to existing PSID studies. We find that the young generation participates in the equity markets for conventional levels of risk aversion and realistic labor income profiles. In contrast to Constantinides, Donaldson and Mehra (2000), our conclusion is that intergenerational heterogeneity and borrowing constraints alone cannot explain the equity premium puzzle. We suggest further research on idiosyncratic labor income shocks within a generation.
