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Asset Pricing with Heterogeneous Investors and Portfolio Constraints

  • Georgy Chabakauri

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    We study dynamic general equilibrium in one-tree and two-trees Lucas economies with one consumption good and two CRRA investors with heterogeneous risk aversions and portfolio constraints. We provide a tractable characterization of equilibrium without relying on the assumption of logarithmic constrained investors, popular in the literature, under which wealthconsumption ratios of these investors are unaffected by constraints. In one-tree economy we focus on the impact of limited stock market participation and margin constraints on market prices of risk, interest rates, stock return volatilities and price-dividend ratios. We demonstrate conditions under which constraints increase or decrease these equilibrium processes, and generate dynamic patterns consistent with empirical findings. In a two-trees economy we demonstrate that investor heterogeneity gives rise to large countercyclical excess stock return correlations, but margin constraints significantly reduce them by restricting the leverage in the economy, and give rise to rich saddle-type patterns. We also derive a new closed-form consumption CAPM that captures the impact of constraints on stock risk premia.

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    File URL: http://www.lse.ac.uk/fmg/workingPapers/discussionPapers/fmgdps/dp707-PWC30.pdf
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    Paper provided by Financial Markets Group in its series FMG Discussion Papers with number dp707.

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    Date of creation: Jul 2012
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    Handle: RePEc:fmg:fmgdps:dp707
    Contact details of provider: Web page: http://www.lse.ac.uk/fmg/

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    1. Daniele Coen-Pirani, 2000. "Margin Requirements and Equilibrium Asset Prices," GSIA Working Papers 2001-E5, Carnegie Mellon University, Tepper School of Business.
    2. Raman Uppal & Harjoat Bhamra, 2013. "Asset Prices with Heterogeneity in Preferences and Beliefs," 2013 Meeting Papers 1344, Society for Economic Dynamics.
    3. Hardouvelis, Gikas A & Pericli, Andreas & Theodossiou, Panayiotis, 1997. "The Asymmetric Relation Between Margin Requirements and Stock Market Volatility Across Bull and Bear Markets," CEPR Discussion Papers 1746, C.E.P.R. Discussion Papers.
    4. Ian Martin, 2013. "The Lucas Orchard," Econometrica, Econometric Society, vol. 81(1), pages 55-111, 01.
    5. Fatih Guvenen, 2009. "A parsimonious macroeconomic model for asset pricing," Staff Report 434, Federal Reserve Bank of Minneapolis.
    6. Hui Chen & Scott Joslin, 2012. "Generalized Transform Analysis of Affine Processes and Applications in Finance," Review of Financial Studies, Society for Financial Studies, vol. 25(7), pages 2225-2256.
    7. Jér�me B. Detemple & René Garcia & Marcel Rindisbacher, 2003. "A Monte Carlo Method for Optimal Portfolios," Journal of Finance, American Finance Association, vol. 58(1), pages 401-446, 02.
    8. Hugonnier, Julien, 2012. "Rational asset pricing bubbles and portfolio constraints," Journal of Economic Theory, Elsevier, vol. 147(6), pages 2260-2302.
    9. Lars Ljungqvist & Thomas J. Sargent, 2004. "Recursive Macroeconomic Theory, 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 026212274x, June.
    10. M. Fatih Guvenen, 2002. "Reconciling Conflicting Evidence on the Elasticity of Intertemporal Substitution: A Macroeconomic Perspective," RCER Working Papers 491, University of Rochester - Center for Economic Research (RCER), revised Mar 2003.
    11. Andrea Buraschi & Paolo Porchia & Fabio Trojani, 2010. "Correlation Risk and Optimal Portfolio Choice," Journal of Finance, American Finance Association, vol. 65(1), pages 393-420, 02.
    12. Jérˆme Detemple & Marcel Rindisbacher, 2005. "Closed-Form Solutions For Optimal Portfolio Selection With Stochastic Interest Rate And Investment Constraints," Mathematical Finance, Wiley Blackwell, vol. 15(4), pages 539-568.
    13. Joost Driessen & Pascal J. Maenhout & Grigory Vilkov, 2009. "The Price of Correlation Risk: Evidence from Equity Options," Journal of Finance, American Finance Association, vol. 64(3), pages 1377-1406, 06.
    14. Cvitanic, Jaksa & Malamud, Semyon, 2011. "Price impact and portfolio impact," Journal of Financial Economics, Elsevier, vol. 100(1), pages 201-225, April.
    15. Harold L. Cole & Hanno & YiLi Chien, 2007. "Macro Implications of Household Finance," 2007 Meeting Papers 479, Society for Economic Dynamics.
    16. Michael Gallmeyer & Burton Hollifield, 2008. "An Examination of Heterogeneous Beliefs with a Short-Sale Constraint in a Dynamic Economy," Review of Finance, European Finance Association, vol. 12(2), pages 323-364.
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