Borrowing Costs and the Demand for Equity Over the Life Cycle

42 Pages Posted: 30 Dec 2003

See all articles by Steven J. Davis

Steven J. Davis

University of Chicago; National Bureau of Economic Research (NBER)

Felix Kubler

University of Zurich; Swiss Finance Institute

Paul Willen

Federal Reserve Bank of Boston - Research Department; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: May 2005

Abstract

We analyze consumption and portfolio behavior in a life-cycle model with realistic borrowing costs and income processes. We show that even a small wedge between borrowing costs and the risk-free return dramatically shrinks the demand for equity. When the cost of borrowing equals or exceeds the expected return on equity - the relevant case according to the data - households hold little or no equity during much of the life cycle. The model also implies that the correlation between consumption growth and equity returns is low at all ages, and that risk aversion estimates based on the standard excess return formulation of the consumption Euler Equation are greatly upward biased. The demand for equity in the model is non-monotonic in borrowing costs and risk aversion, and the standard deviation of marginal utility growth is an order of magnitude smaller than the Sharpe ratio.

JEL Classification: D91, G11, G12

Suggested Citation

Davis, Steven J. and Kubler, Felix E. and Willen, Paul S., Borrowing Costs and the Demand for Equity Over the Life Cycle (May 2005 ). AFA 2004 San Diego Meetings ; FRB of Boston Working Paper No. 05-7 . Available at SSRN: https://ssrn.com/abstract=483582 or http://dx.doi.org/10.2139/ssrn.483582

Steven J. Davis (Contact Author)

University of Chicago ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
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National Bureau of Economic Research (NBER)

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Felix E. Kubler

University of Zurich ( email )

Rämistrasse 71
Zürich, CH-8006
Switzerland

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Paul S. Willen

Federal Reserve Bank of Boston - Research Department ( email )

600 Atlantic Avenue
Boston, MA 02210
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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