Using Financial Assets to Hedge Labor Income Risks: Estimating the Benefits

Abstract

We characterize the covariance structure between asset returns and labor income shocks for synthetic persons defined in terms of sex, education and birth cohort. The correlation of income shocks with both aggregate and own-industry equity returns tends to rise with educational attainment and, surprisingly, is negative for several sex-education groups. We then develop a tractable equilibrium life-cycle model with incomplete markets. We implement the model using the estimated covariance structure and other data in order to evaluate the portfolio choice and welfare implications of hedging with financial assets. There are large equilibrium risk-sharing gains from trading a ”full menu” of group-level assets, exceeding 15,000 dollars in present value for many persons, and a single asset can generate sizable gains for certain demographic groups. The hedging motive has significant consequences for the structure of the optimal portfolio.

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