Model Uncertainty, Limited Market Participation and Asset Prices

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.