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Limited stock market participation and asset prices in a dynamic economy

Hui Guo ()

No 2000-031, Working Papers from Federal Reserve Bank of St. Louis

Abstract: 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.

Keywords: Stock - Prices; Stock market; Asset pricing (search for similar items in EconPapers)
Date: 2003
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Published in Journal of Financial and Quantitative Analysis, September 2004, 39(3), pp. 495-516

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