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

Kogan, L, Makarov, I and Uppal, R (2003) Equity risk premium and the riskfree rate in an economy with borrowing constraints. Working Paper. London Business School IFA Working Paper.

Abstract

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 representativeagent 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 representativeagent economies and unconstrained heterogeneousagent economies.