Asset Pricing with Heterogeneous and Constrained Investors

Abstract

This paper studies the joint effect of borrowing and short-sale constraints under heterogeneous beliefs and risk aversions. Although the constraints never bind simultaneously in equilibrium, there is interesting economics in the anticipatory effects of potentially future binding constraints. In particular, the risk-free rate and Sharpe ratio experience endogenous jumps at a critical state, where two equilibria co-exist. Moreover, a short-sale ban can lead to a lower stock price and higher volatility depending the relative tightness between the constraints, and tightening the borrowing constraint during a short-sale ban can also make returns more volatile.