Limited Asset Market Participation and the Variation of Real Risk Premia

Abstract

This paper studies the contribution of limited asset market participation to the variability of real interest rates in the UK. Using a quadratic term structure model of real interest rates in an economy with endogenously segmented asset markets, I estimate the contribution of money and real shocks to the volatility of interest rates. The estimates suggest that the consumption of households participating in the asset market has time-varying conditional variances and varies more in response to money shocks when inflation is close to its unconditional mean. Asset market segmentation is an uninsurable risk which varies more at lower levels of inflation because more households are ready to participate at low levels than at high levels of inflation. Consequently, participating households bear a larger portion of aggregate consumption variability. The endogenous asset market segmentation generates the rejection of the expectations hypothesis in real interest rates.

Keywords: general equilibrium asset pricing, limited asset market participation, risk premia variation, expectations hypothesis

JEL Classification: E43, E44, G12