TCMay09 - Intertemporal Consumption Choices Transaction...

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Unformatted text preview: Intertemporal Consumption Choices, Transaction Costs and Limited Participation in Financial Markets: Reconciling Data and Theory Orazio P. Attanasio University College London, IFS and NBER Monica Paiella University of Naples ”Parthenope” May 15, 2009 Abstract This paper builds a unifying framework based on the theory of intertemporal consumption choices that brings together the limited participation-based explanation of the C-CAPM poor empirical per- formance and the transaction costs-based explanation of incomplete portfolios. Using the implications of the consumption model and ob- served household consumption and portfolio choices, we identify the preference parameters of interest and a lower bound for the costs ra- tionalizing non-participation in financial markets. Using the US Con- sumer Expenditure Survey and assuming isoelastic preferences, we es- timate the coefficient of relative risk aversion at 1.7 and a cost bound of 0.4 percent of non-durable consumption. Our estimate of the pref- erence parameter is theoretically plausible and the bound sufficiently small to be likely to be exceeded by the actual total (observable and unobservable) costs of participating in financial markets. Keywords: limited participation in financial markets, fixed par- ticipation costs, Euler equation for consumption. 1 1 Introduction The dynamics of consumption and saving behavior are obviously related to the demand for assets and, as such, can provide valuable information for equilibrium asset pricing. The pathbreaking contributions of Lucas (1978) and Breeden (1979) made the link between the Euler equation for consump- tion and equilibrium asset prices explicit and used the first-order conditions of a consumer problem to build what is known as the Consumption Capital Asset Pricing Model (C-CAPM). Unfortunately, despite the formal elegance and the analytical simplicity of the C-CAPM, the empirical performance of the model has been, at best, mixed. Since the early studies by Hansen and Singleton (1982, 1983), it has been clear that observed asset returns were in- consistent with the dynamics of consumption choices, at least as observed in aggregate data. This evidence was reinforced and confirmed in a large num- ber of other studies. Some studies, such as Hansen and Jagannathan (1991), suggested that one of the reasons for the poor empirical performance of the model was the low level of variability of aggregate consumption growth. Recently, there have been several attempts at rationalizing this discour- aging evidence and several studies have explored the possibility that limited participation in financial markets might explain the disparity between the- oretical predictions and empirical evidence. More precisely, since the first- order conditions of asset pricing models hold with equality only for those households who own complete portfolios, the models should be tested for this subset of households and not for the whole population. As a conse- quence, since in practice relatively few households hold shares directly, even...
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TCMay09 - Intertemporal Consumption Choices Transaction...

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