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Limited Stock Market Participation and Asset Prices in a Dynamic Economy

Published online by Cambridge University Press:  06 April 2009

Hui Guo
Hui Guo
Affiliation:
hui.guo@stls.frb.org, Research Department, Federal Reserve Bank of St. Louis, 411 Locust St., St. Louis, MO 63102.
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Abstract

This paper presents 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. This 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.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 39 , Issue 3 , September 2004 , pp. 495 - 516
Copyright
Copyright © School of Business Administration, University of Washington 2004

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