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Limited stock market participation and asset prices in a dynamic economy

  • Hui Guo
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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
Date of revision:
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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  9. Kjetil Storesletten & Chris Telmer & Amir Yaron, . "Asset pricing with idiosyncratic risk and overlapping generations," GSIA Working Papers 226, Carnegie Mellon University, Tepper School of Business.
  10. Kris Jacobs, 1999. "Incomplete Markets and Security Prices: Do Asset-Pricing Puzzles Result from Aggregation Problems?," Journal of Finance, American Finance Association, vol. 54(1), pages 123-163, 02.
  11. John H. Cochrane, 1989. "Explaining the Variance of Price Dividend Ratios," NBER Working Papers 3157, National Bureau of Economic Research, Inc.
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  13. Campbell, John, 1987. "Stock Returns and the Term Structure," Scholarly Articles 3207699, Harvard University Department of Economics.
  14. 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.
  15. Heaton, John & Lucas, Deborah J, 1996. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 443-87, June.
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  19. Hayashi, Fumio & Altonji, Joseph & Kotlikoff, Laurence, 1996. "Risk-Sharing between and within Families," Econometrica, Econometric Society, vol. 64(2), pages 261-94, March.
  20. Allen, F. & Gale, D., 1991. "Limited Market Participation and Volatility of Asset Prices," Weiss Center Working Papers 2-92, Wharton School - Weiss Center for International Financial Research.
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  22. Poterba, James M. & Summers, Lawrence H., 1988. "Mean reversion in stock prices : Evidence and Implications," Journal of Financial Economics, Elsevier, vol. 22(1), pages 27-59, October.
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  24. Lucas, Deborah J., 1994. "Asset pricing with undiversifiable income risk and short sales constraints: Deepening the equity premium puzzle," Journal of Monetary Economics, Elsevier, vol. 34(3), pages 325-341, December.
  25. Philippe Weil, 1989. "The Equity Premium Puzzle and the Riskfree Rate Puzzle," NBER Working Papers 2829, National Bureau of Economic Research, Inc.
  26. Tauchen, George & Hussey, Robert, 1991. "Quadrature-Based Methods for Obtaining Approximate Solutions to Nonlinear Asset Pricing Models," Econometrica, Econometric Society, vol. 59(2), pages 371-96, March.
  27. Constantinides,George & Duffie,Darrel, 1992. "Asset pricing with heterogeneous consumers," Discussion Paper Serie A 381, University of Bonn, Germany.
  28. 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, vol. 53(2), pages 575-603, 04.
  29. George M. Constantinides & John B. Donaldson & Rajnish Mehra, 2002. "Junior Can't Borrow: A New Perspective on the Equity Premium Puzzle," The Quarterly Journal of Economics, Oxford University Press, vol. 117(1), pages 269-296.
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