The equity risk premium and the riskfree rate in an economy with borrowing constraints |
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Authors: | Leonid Kogan Igor Makarov Raman Uppal |
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Affiliation: | (1) Sloan School of Management E52-434, Massachusetts Institute of Technology, 50 Memorial Drive, Cambridge, MA 02142, USA;(2) London Business School, 6 Sussex Place, Regent’s Park, NW1 4SA London, UK;(3) CEPR and London Business School, 6 Sussex Place, Regent’s Park, NW1 4SA London, UK |
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Abstract: | Our objective is to study analytically the effect of borrowing constraints on asset returns. We explicitly characterize the equilibrium for an exchange economy with two agents who differ in their risk aversion and are prohibited from borrowing. In a representative-agent economy with CRRA preferences, the Sharpe ratio of equity returns and the riskfree rate are linked by the risk aversion parameter. We show that allowing for preference heterogeneity and imposing borrowing constraints breaks this link. We find that an economy with borrowing constraints exhibits simultaneously a relatively high Sharpe ratio of stock returns and a relatively low riskfree interest rate, compared to both representative-agent and unconstrained heterogeneous-agent economies. |
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Keywords: | Incomplete markets Portfolio choice Asset pricing General equilibrium |
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