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Limited stock market participation and asset prices in a dynamic economy

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  • Hui Guo
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Abstract

We present a consumption-based model that explains the equity premium puzzle through two channels. First, because of borrowing constraints, the shareholder cannot completely diversify his income risk and requires a sizable risk premium on stocks. Second, because of limited stock market participation, the precautionary saving demand lowers the risk-free rate but not stock return and generates a substantial liquidity premium. Our model also replicates many other salient features of the data, including the first two moments of the risk-free rate, excess stock volatility, stock return predictability, and the unstable relation between stock volatility and the dividend yield.

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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2000-031.

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Date of creation: 2003
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Publication status: Published in Journal of Financial and Quantitative Analysis, September 2004, 39(3), pp. 495-516
Handle: RePEc:fip:fedlwp:2000-031

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Keywords: Stock - Prices ; Stock market ; Asset pricing;

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  1. George M. Constantinides & John B. Donaldson & Rajnish Mehra, . "Junior Can't borrow: A New Perspective on the Equity Premium Puzzle."," CRSP working papers 457, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  2. Greenwood, J. & Jovanovic, B., 1999. "The IT Revolution and the Stock Market," Working Papers, C.V. Starr Center for Applied Economics, New York University 99-02, C.V. Starr Center for Applied Economics, New York University.
  3. John Y. Campbell, 1985. "Stock Returns and the Term Structure," NBER Working Papers 1626, National Bureau of Economic Research, Inc.
  4. Chris I. Telmer, 1991. "Asset Pricing Puzzles and Incomplete Markets," Working Papers, Queen's University, Department of Economics 806, Queen's University, Department of Economics.
  5. Weil, Philippe, 1989. "The equity premium puzzle and the risk-free rate puzzle," Journal of Monetary Economics, Elsevier, Elsevier, vol. 24(3), pages 401-421, November.
  6. G. William Schwert, 1990. "Why Does Stock Market Volatility Change Over Time?," NBER Working Papers 2798, National Bureau of Economic Research, Inc.
  7. Poterba, James M. & Summers, Lawrence H., 1988. "Mean reversion in stock prices : Evidence and Implications," Journal of Financial Economics, Elsevier, Elsevier, vol. 22(1), pages 27-59, October.
  8. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, Econometric Society, vol. 41(5), pages 867-87, September.
  9. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 107(2), pages 205-251, April.
  10. Mankiw, N.G. & Zeldes, S.P., 1990. "The Consumption Of Stockholders And Non-Stockholders," Weiss Center Working Papers, Wharton School - Weiss Center for International Financial Research 23-90, Wharton School - Weiss Center for International Financial Research.
  11. Robert J. Shiller, 1980. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," NBER Working Papers 0456, National Bureau of Economic Research, Inc.
  12. Basak, Suleyman & Cuoco, Domenico, 1998. "An Equilibrium Model with Restricted Stock Market Participation," Review of Financial Studies, Society for Financial Studies, vol. 11(2), pages 309-41.
  13. Robert J. Shiller & John Y. Campbell, 1986. "The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 812, Cowles Foundation for Research in Economics, Yale University.
  14. Kjetil Storesletten & Chris Telmer & Amir Yaron, . "Asset pricing with idiosyncratic risk and overlapping generations," GSIA Working Papers, Carnegie Mellon University, Tepper School of Business 226, Carnegie Mellon University, Tepper School of Business.
  15. John T. Scruggs, 1998. "Resolving the Puzzling Intertemporal Relation between the Market Risk Premium and Conditional Market Variance: A Two-Factor Approach," Journal of Finance, American Finance Association, American Finance Association, vol. 53(2), pages 575-603, 04.
  16. Constantinides, George M & Duffie, Darrell, 1996. "Asset Pricing with Heterogeneous Consumers," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 104(2), pages 219-40, April.
  17. N. Gregory Mankiw, 1986. "The Equity Premium and the Concentration of Aggregate Shocks," NBER Working Papers 1788, National Bureau of Economic Research, Inc.
  18. Cochrane, John H, 1992. "Explaining the Variance of Price-Dividend Ratios," Review of Financial Studies, Society for Financial Studies, vol. 5(2), pages 243-80.
  19. Hayashi, Fumio & Altonji, Joseph & Kotlikoff, Laurence, 1996. "Risk-Sharing between and within Families," Econometrica, Econometric Society, Econometric Society, vol. 64(2), pages 261-94, March.
  20. Lucas, Deborah J., 1994. "Asset pricing with undiversifiable income risk and short sales constraints: Deepening the equity premium puzzle," Journal of Monetary Economics, Elsevier, Elsevier, vol. 34(3), pages 325-341, December.
  21. Allen, Franklin & Gale, Douglas, 1994. "Limited Market Participation and Volatility of Asset Prices," American Economic Review, American Economic Association, vol. 84(4), pages 933-55, September.
  22. Fama, Eugene F. & French, Kenneth R., 1989. "Business conditions and expected returns on stocks and bonds," Journal of Financial Economics, Elsevier, Elsevier, vol. 25(1), pages 23-49, November.
  23. John Heaton & Deborah Lucas, 1993. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," NBER Working Papers 4249, National Bureau of Economic Research, Inc.
  24. French, Kenneth R. & Schwert, G. William & Stambaugh, Robert F., 1987. "Expected stock returns and volatility," Journal of Financial Economics, Elsevier, Elsevier, vol. 19(1), pages 3-29, September.
  25. Tauchen, George & Hussey, Robert, 1991. "Quadrature-Based Methods for Obtaining Approximate Solutions to Nonlinear Asset Pricing Models," Econometrica, Econometric Society, Econometric Society, vol. 59(2), pages 371-96, March.
  26. Kris Jacobs, 1999. "Incomplete Markets and Security Prices: Do Asset-Pricing Puzzles Result from Aggregation Problems?," Journal of Finance, American Finance Association, American Finance Association, vol. 54(1), pages 123-163, 02.
  27. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, Elsevier, vol. 15(2), pages 145-161, March.
  28. Hui Guo, 2002. "Understanding the risk-return tradeoff in the stock market," Working Papers, Federal Reserve Bank of St. Louis 2002-001, Federal Reserve Bank of St. Louis.
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