Limited Stock Market Participation and Asset Prices in a Dynamic Economy
Hui Guo ()
Journal of Financial and Quantitative Analysis, 2004, vol. 39, issue 3, 495-516
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.
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Working Paper: Limited stock market participation and asset prices in a dynamic economy (2003)
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