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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 borrowings. 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.

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Paper provided by Federal Reserve Bank of Boston in its series Working Papers with number 05-7.

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Date of creation: 2005
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Handle: RePEc:fip:fedbwp:05-7
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