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Limited financial market participation: a transaction cost-based explanation

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  • Monica Paiella

    (Institute for Fiscal Studies)

Abstract

This paper focuses on the issue of limited financial market participation and determines a lower bound on the level of fixed transaction costs that are required to reconcile observed portfolio choices with asset returns within an isoelastic utility framework. The bound is determined from the set of conditions that ensure the optimality of consumption behavior by financial market non-participants. It represents the lowest possible cost rationalizing observed non-participation choices by providing a measure of the forgone utility gains from participation for observed non-participants. Such gains are related both to the magnitude of financial market returns and to the opportunity of smoothing consumption, with the benefits of the former decreasing in the degree of relative risk aversion and those of the latter increasing in it. Using the US Consumer Expenditure Survey, I find that a yearly cost of at least $70 is needed to rationalize non-participation for a consumer with log utility and who can trade in the S&P500 CI. This lower bound declines rapidly in risk aversion for levels of risk aversion up to two/three; for higher values, it levels off. A yearly cost of at least $31 is needed to rationalize non-participation for a consumer with log utility and who can trade in US Treasury Bills. This lower bound rises steadily in risk aversion.
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  • Monica Paiella, 2001. "Limited financial market participation: a transaction cost-based explanation," IFS Working Papers W01/06, Institute for Fiscal Studies.
    • Handle: RePEc:ifs:ifsewp:01/06
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    Cited by:

    1. Monica Paiella, 2007. "The Forgone Gains of Incomplete Portfolios," Review of Financial Studies, Society for Financial Studies, vol. 20(5), pages 1623-1646, 2007 13.
    2. Korniotis, George & Bonaparte, Yosef & Kumar, Alok, 2020. "Income Risk and Stock Market Entry/Exit Decisions," CEPR Discussion Papers 15370, C.E.P.R. Discussion Papers.
    3. Luigi Guiso & Michael Haliassos & Tullio Jappelli, 2003. "Household stockholding in Europe: where do we stand and where do we go? [‘Limited market participation and volatility of assets prices’]," Economic Policy, CEPR;CES;MSH, vol. 18(36), pages 123-170.
    4. Claudio Campanale, 2007. "Increasing Returns to Savings and Wealth Inequality," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 10(4), pages 646-675, October.
    5. Ragot, Xavier, 2014. "The case for a financial approach to money demand," Journal of Monetary Economics, Elsevier, vol. 62(C), pages 94-107.
    6. repec:hal:spmain:info:hdl:2441/4vm8e5vhjr99cb1ekr86bivlk0 is not listed on IDEAS
    7. Shum, Pauline & Faig, Miquel, 2006. "What explains household stock holdings?," Journal of Banking & Finance, Elsevier, vol. 30(9), pages 2579-2597, September.
    8. Campanale, Claudio, 2009. "Life-cycle portfolio choice: The role of heterogeneous under-diversification," Journal of Economic Dynamics and Control, Elsevier, vol. 33(9), pages 1682-1698, September.
    9. Valentina Michelangeli & Eliana Viviano, 2021. "Can internet banking affect households' participation in financial markets and financial awareness?," Temi di discussione (Economic working papers) 1329, Bank of Italy, Economic Research and International Relations Area.
    10. Luigi Guiso & Tullio Jappelli, 2005. "Awareness and Stock Market Participation," Review of Finance, European Finance Association, vol. 9(4), pages 537-567.
    11. Muhammet Fatih Guvenen, 2000. "Does Stockholding Provide Perfect Risk Sharing?," GSIA Working Papers 2000-E48, Carnegie Mellon University, Tepper School of Business.
    12. Yannis Bilias & Michael Haliassos, 2004. "The Distribution of Gains from Access to Stocks," CSEF Working Papers 125, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.
    13. Claudio Campanale, 2011. "Learning, Ambiguity and Life-Cycle Portfolio Allocation," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 14(2), pages 339-367, April.
    14. Sule Alan, 2006. "Entry Costs and Stock Market Participation over the Life Cycle," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 9(4), pages 588-611, October.
    15. Zhou, Jie, 2012. "Life-cycle stock market participation in taxable and tax-deferred accounts," Journal of Economic Dynamics and Control, Elsevier, vol. 36(11), pages 1814-1829.
    16. Francesco Spadafora, 2002. "Financial crises, moral hazard and the "speciality" of the international interbank market: further evidence from the pricing of syndicated bank loans to emerging markets," Temi di discussione (Economic working papers) 438, Bank of Italy, Economic Research and International Relations Area.
    17. Jaime Ruiz-Tagle, 2006. "Financial Markets Incompleteness and Inequality Over the Life-Cycle," Working Papers Central Bank of Chile 405, Central Bank of Chile.
    18. Zvi Bodie & Jérôme Detemple & Marcel Rindisbacher, 2009. "Life-Cycle Finance and the Design of Pension Plans," Annual Review of Financial Economics, Annual Reviews, vol. 1(1), pages 249-286, November.

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    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • E12 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Keynes; Keynesian; Post-Keynesian; Modern Monetary Theory
    • D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory

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