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Borrowing Costs and the Demand for Equity over the Life Cycle

  • Steven J. Davis
  • Felix Kubler
  • Paul Willen

We construct a life cycle model that delivers realistic behavior for both equity holdings and borrowing. The key model ingredient is a wedge between the cost of borrowing and the risk-free investment return. Borrowing can either raise or lower equity demand, depending on the cost of borrowing. A borrowing rate equal to the expected return on equity-which we show roughly matches the data-minimizes the demand for equity. Alternative models with no borrowing or limited borrowing at the risk-free rate cannot simultaneously fit empirical evidence on borrowing and equity holdings. Copyright by the President and Fellows of Harvard College and the Massachusetts Institute of Technology.

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File URL: http://www.mitpressjournals.org/doi/pdf/10.1162/rest.88.2.348
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Article provided by MIT Press in its journal The Review of Economics and Statistics.

Volume (Year): 88 (2006)
Issue (Month): 2 (May)
Pages: 348-362

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Handle: RePEc:tpr:restat:v:88:y:2006:i:2:p:348-362
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