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Limited stock market participation and asset prices in a dynamic economy

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  • Hui Guo

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.

Suggested Citation

  • Hui Guo, 2003. "Limited stock market participation and asset prices in a dynamic economy," Working Papers 2000-031, Federal Reserve Bank of St. Louis.
  • Handle: RePEc:fip:fedlwp:2000-031
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    Keywords

    Stock - Prices; Stock market; Asset pricing;
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