Borrowing Costs and the Demand for Equity Over the Life Cycle
Steven J. Davis
University of Chicago; National Bureau of Economic Research (NBER)
University of Zurich; Swiss Finance Institute
Federal Reserve Bank of Boston - Research Department; National Bureau of Economic Research (NBER)
AFA 2004 San Diego Meetings
FRB of Boston Working Paper No. 05-7
We analyze consumption and portfolio behavior in a life-cycle model with realistic borrowing costs and income processes. We show that even a small wedge between borrowing costs and the risk-free return dramatically shrinks the demand for equity. When the cost of borrowing equals or exceeds the expected return on equity - the relevant case according to the data - households hold little or no equity during much of the life cycle. The model also implies that the correlation between consumption growth and equity returns is low at all ages, and that risk aversion estimates based on the standard excess return formulation of the consumption Euler Equation are greatly upward biased. The demand for equity in the model is non-monotonic in borrowing costs and risk aversion, and the standard deviation of marginal utility growth is an order of magnitude smaller than the Sharpe ratio.
Number of Pages in PDF File: 42
JEL Classification: D91, G11, G12working papers series
Date posted: December 30, 2003
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