Junior Can't Borrow: a New Perspective on the Equity Premium Puzzle

36 Pages Posted: 26 Jul 2000 Last revised: 10 Oct 2010

See all articles by George M. Constantinides

George M. Constantinides

University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)

John B. Donaldson

Columbia Business School - Finance and Economics

Rajnish Mehra

Arizona State University (ASU) - W.P Carey School of Business, Department of Economics; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: June 1998

Abstract

Ongoing questions on the historical mean and standard deviation of the return on equities and bonds and on the equilibrium demand for these securities are addressed in the context of a stationary, overlapping-generations economy in which consumers are subject to a borrowing constraint. The key feature captured by the OLG economy is that the bulk of the future income of the young agents is derived from their wages forthcoming in their middle age, while the bulk of the future income of the middle-aged agents is derived from their savings in equity and bonds. The young would like to borrow and invest in equity, but the borrowing constraint prevents them from doing so. The middle-aged choose to hold a diversified portfolio that includes positive holdings of bonds, and this explains the demand for bonds. Without the borrowing constraint, the young borrow and invest in equity, thereby decreasing the mean equity premium and increasing the rate of interest.

Suggested Citation

Constantinides, George M. and Donaldson, John B. and Mehra, Rajnish, Junior Can't Borrow: a New Perspective on the Equity Premium Puzzle (June 1998). NBER Working Paper No. w6617. Available at SSRN: https://ssrn.com/abstract=226337

George M. Constantinides (Contact Author)

University of Chicago - Booth School of Business ( email )

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National Bureau of Economic Research (NBER)

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John B. Donaldson

Columbia Business School - Finance and Economics ( email )

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Rajnish Mehra

Arizona State University (ASU) - W.P Carey School of Business, Department of Economics ( email )

Tempe, AZ 85287-3806
United States
480 965 6335 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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