Asset Pricing with Heterogeneous Risk Aversion and Portfolio Constraints

(Job Market Paper)

This paper investigates the effects of portfolio constraints on asset returns and volatility. Portfolio constraints may arise due to minimum capital

requirement regulations, margin requirements or leverage constraints on portfolio managers. In a continuous time, pure exchange economy we

analyze how heterogeneity in preferences affect the equilibrium stock price, stock returns and volatility in the presence of portfolio constraints.

Previous partial equilibrium literature showed that margin requirements increase the volatility of stock prices. In contrast to these results, we

show that stock returns volatility decreases when the constraint binds. The effect of the constraint in decreasing the stock returns volatility is

most pronounced when the constraint binds in the bad state of the economy and the unconstrained investor is poorer than the constrained

investor. Given the empirical evidence in support of the stylized fact that stock returns volatility is counter-cyclical, our findings therefore suggest

that margin requirements are indeed effective in mitigating the wild fluctuations in the stock market volatility when prices go low. Moreover,

portfolio constraints can simultaneously produce high equity Sharpe ratio and low interest rates in equilibrium, partly explaining the equity

premium and risk-free interest rate puzzles. We also perform a welfare analysis and show that the unconstrained investor is better off while the

constrained investor is worse off when the constraint binds.