Equity risk premium and the riskfree rate in an economy with borrowing constraints

Finance

IFA Working Paper

2003

Our objective in this article 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 risk free 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 economies and unconstrained heterogeneous-agent economies.

Institute of Finance and Accounting

FIN 388

IFA Working Paper

No