The Composition of Market Participants and Asset Dynamics

Abstract

We develop a dynamic equilibrium model where heterogeneous investors endogenously choose to enter/exit the stock market. We characterize the equilibrium and present a conditional consumption-CAPM. The model implies small changes in the composition of stockholders, which generate a strongly countercyclical stockholders’ amount of consumption risk. The model provides a new perspective on the main drivers of asset dynamics. It is the procyclical consumption risk-sharing implied by changes in stockholders' composition that contributes to the dynamics of risk premium, excess volatility, and price-dividend ratio. We provide empirical evidence on market participation, amount of risk, and price of risk, supporting our theory.

Keywords: time-varying composition of stockholders, consumption risk, heterogeneous investors, conditional consumption-based asset pricing, labor income, recursive utility

JEL Classification: G11, G12, G17