Creator: Allen, Franklin, 1956- and Gale, Douglas Series: Monetary theory and financial intermediation Abstract:
Traditional theories of asset pricing assume there is complete market participation so all investors participate in all markets. In this case changes in preferences typically have only a small effect on asset prices and are not an important determinant of asset price volatility. However, there is considerable empirical evidence that most investors participate in a limited number of markets. We show that limited market participation can amplify the effect of changes in preferences so that an arbitrarily small degree of aggregate uncertainty in preferences can cause a large degree of price volatility. We also show that in addition to this equilibrium with limited participation and volatile asset prices, there may exist a Pareto-preferred equilibrium with complete participation and less volatility.
Subject (JEL): C58 - Financial Econometrics and G12 - General financial markets - Asset pricing ; Trading volume ; Bond interest rates