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Limited financial market participation: a transaction cost-based explanation

Paiella, M.; (2001) Limited financial market participation: a transaction cost-based explanation. (IFS Working Papers W01/06). Institute for Fiscal Studies: London, UK. Green open access

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Abstract

This paper focuses on the issue of limited financial market participation and determines a lower bound on the level of fixed transaction costs that are required to reconcile observed portfolio choices with asset returns within an isoelastic utility framework. The bound is determined from the set of conditions that ensure the optimality of consumption behavior by financial market non-participants. It represents the lowest possible cost rationalizing observed non-participation choices by providing a measure of the forgone utility gains from participation for observed non-participants. Such gains are related both to the magnitude of financial market returns and to the opportunity of smoothing consumption, with the benefits of the former decreasing in the degree of relative risk aversion and those of the latter increasing in it. Using the US Consumer Expenditure Survey, I find that a yearly cost of at least $70 is needed to rationalize non-participation for a consumer with log utility and who can trade in the S&P500 CI. This lower bound declines rapidly in risk aversion for levels of risk aversion up to two/three; for higher values, it levels off. A yearly cost of at least $31 is needed to rationalize non-participation for a consumer with log utility and who can trade in US Treasury Bills. This lower bound rises steadily in risk aversion.

Type: Working / discussion paper
Title: Limited financial market participation: a transaction cost-based explanation
Open access status: An open access version is available from UCL Discovery
Publisher version: http://www.ifs.org.uk/publications/browse/type/wp
Language: English
Keywords: JEL classification: G11, D12, E21. Household portfolio allocation, financial market participation, transaction costs, heterogeneous consumers
UCL classification: UCL > Provost and Vice Provost Offices > UCL SLASH > Faculty of SandHS > Dept of Economics
URI: http://discovery.ucl.ac.uk/id/eprint/3863
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