Asset Pricing with Heterogeneous and Constrained Investors

40 Pages Posted: 16 Aug 2018 Last revised: 24 May 2019

See all articles by Lei Shi

Lei Shi

Macquarie University; Financial Research Network (FIRN)

Yajun Xiao

University College Dublin (UCD)

Date Written: August 3, 2018


We analyze the joint effect of borrowing and short-sale constraints in a dynamic economy populated by two constrained investors with heterogeneous risk aversions and beliefs. We find that equilibrium prices adjust in such a way that the constraints never simultaneously bind. When the constraints are tight, we observe a regime switch behavior (discontinuities) in the risk-free rate and market price of risk at a critical state, where two equilibria exist, i.e., either constraint can be binding. Stock return volatility is the lowest at the critical state. Imposing a ban on short-sales at the same time when access to credit is restrictive or tightening borrowing during a short-sale ban can potentially move the equilibrium away from the critical state, thus increase stock return volatility rather than reducing it.

Keywords: Heterogeneous Investors; Borrowing Constraints; Short-Sale Constraints; Volatility; Regime Switch

JEL Classification: C61; D51; G11; G12

Suggested Citation

Shi, Lei and Xiao, Yajun, Asset Pricing with Heterogeneous and Constrained Investors (August 3, 2018). Macquarie University Faculty of Business & Economics Research Paper. Available at SSRN: or

Lei Shi (Contact Author)

Macquarie University ( email )

New South Wales 2109
+612 98508478 (Phone)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane


Yajun Xiao

University College Dublin (UCD) ( email )

Belfield, Dublin 4 4

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