This essay reviews the family of models that seek to provide aggregate risk based explanations for the empirically observed equity premium. Theories based on non-expected utility preference structures, limited financial market participation, model uncertainty and the small probability of...

In Merton (1987), idiosyncratic risk is priced in equilibrium as a consequence of incomplete diversification. We modify this model to allow the degree of diversification to vary with average idiosyncratic volatility. This simple recognition results in a state-dependent idiosyncratic risk premium...