Model Uncertainty, Limited Market Participation and Asset Prices

48 Pages Posted: 23 Jul 2003

See all articles by H. Henry Cao

H. Henry Cao

University of North Carolina (UNC) at Chapel Hill - Finance Area

Harold H. Zhang

University of Texas at Dallas - Naveen Jindal School of Management; China Academy of Financial Research (CAFR)

Tan Wang

University of British Columbia (UBC) - Division of Finance; China Academy of Financial Research (CAFR)

Date Written: January 6, 2003

Abstract

We demonstrate that limited participation can arise endogenously in the presence of model uncertainty. Our model generates novel predictions on how limited participation relates to equity premium and diversification discount. When the dispersion in investors' model uncertainty is small, full participation prevails in equilibrium. In this case, equity premium is unrelated to model uncertainty dispersion and a conglomerate trades at a price equal to the sum of its single segment counterparts. When model uncertainty dispersion is large, however, investors with relatively high uncertainty optimally choose to stay sidelined in equilibrium. In this case, equity premium can decrease with model uncertainty dispersion. This is in sharp contrast to the understanding in the existing literature that limited participation leads to higher equity premium. Moreover, when limited participation occurs, a conglomerate trades at a discount relative to its single segment counterparts. The discount increases in model uncertainty dispersion and is positively related to the proportion of investors not participating in the markets.

Suggested Citation

Cao, Huining Henry and Zhang, Harold Huibing and Wang, Tan, Model Uncertainty, Limited Market Participation and Asset Prices (January 6, 2003). EFA 2003 Annual Conference Paper No. 94; Sauder School of Business Working Paper. Available at SSRN: https://ssrn.com/abstract=423920 or http://dx.doi.org/10.2139/ssrn.423920

Huining Henry Cao (Contact Author)

University of North Carolina (UNC) at Chapel Hill - Finance Area ( email )

Kenan-Flagler Business School
Chapel Hill, NC 27599-3490
United States

Harold Huibing Zhang

University of Texas at Dallas - Naveen Jindal School of Management ( email )

P.O. Box 830688
Richardson, TX 75083-0688
United States

China Academy of Financial Research (CAFR)

1954 Huashan Road
Shanghai P.R.China, 200030
China

Tan Wang

University of British Columbia (UBC) - Division of Finance ( email )

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada
604-822-9414 (Phone)
604-822-8521 (Fax)

China Academy of Financial Research (CAFR)

1954 Huashan Road
Shanghai P.R.China, 200030
China

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