Limited Stock Market Participation and Asset Prices in a Dynamic Economy
55 Pages Posted: 12 Jun 2003
Date Written: October 2002
We present a consumption-based heterogeneous agent model that explains the equity premium puzzle and many associated asset pricing phenomena. The success of the model relies on a combination of limited stock market participation with uninsurable income risk and borrowing constraints. The two latter frictions - as shown by the early authors - generate a precautionary saving demand for tradable assets such as one-period discount bonds, and thus lower the risk-free rate. However, there is no precautionary saving demand for stocks because of limited stock market participation; therefore, our model generates a sizeable equity premium. Also, in the presence of borrowing constraints, the shareholder's consumption growth or the pricing kernel of stocks mirrors his income growth, which is volatile and mean-reverting. Stock prices, therefore, exhibit excess volatility as well as predictability. Moreover, the model predicts that stock market volatility is a U-shaped function of the price-dividend ratio, which helps explain the 'perverse' negative risk-return tradeoff documented in the literature. The argument for a leverage effect is thus not always valid; stock return is negatively related to contemporaneous conditional volatility mainly because of a volatility feedback effect.
Keywords: limited stock market participation, borrowing constraints, uninsurable income risk, equity premium puzzle, excess volatility, stock return predictability, risk-return tradeoff in stock market, leverage effect, volatility feedback effect.
JEL Classification: C68, E21, G10
Suggested Citation: Suggested Citation