By Ian Martin
This paper investigates the behavior of asset prices in an endowment economy in which a representative agent with power utility consumes the dividends of multiple assets. The assets are Lucas trees; a collection of Lucas trees is a Lucas orchard. The model generates return correlations that vary endogenously, spiking at times of disaster. Since disasters spread across assets, the model generates large risk premia even for assets with stable fundamentals. Very small assets may comove endogenously and hence earn positive risk premia even if their fundamentals are independent of the rest of the economy. I provide conditions under which the variation in a small asset’s price-dividend ratio can be attributed almost entirely to variation in its risk premium.
Besides the cute title, this paper shows how returns are correlated across assets even when fundamentals are not. In the current context, this seems particularly relevant. This week even an new issue of German Treasury bonds had difficulties selling out even though has doubted the fundamentals of Germany. This paper rationalizes this.