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CAN FINANCING CONSTRAINTS EXPLAIN THE ASSET PRICING PUZZLES IN PRODUCTION ECONOMIES?

Authors

  • Katherine A. Smith

    1. U.S. Naval Academy, U.S.A.
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    • The author would like to thank Enrique Mendoza, Jonathan Heathcote, Kent Kimbrough and Michelle Connolly for many helpful comments on an earlier version of this article. Please address correspondence to: Katherine A. Smith, Department of Economics, U.S. Naval Academy, 589 McNair Road, Annapolis, MD 21402, USA. E-mail: ksmith@usna.edu.


  • Manuscript received January 2008; revised September 2009.

Abstract

General Equilibrium asset pricing models have a difficult time simultaneously delivering a sizable equity premium, a low and counter cyclical real risk free rate, and cyclical variation in return volatility. To explain these stylized facts, this article introduces occasionally binding financing constraints that impede producers’ ability to invest. The financial frictions drive a wedge between the marginal rate of substitution and firms’ internal stochastic discount factors so that the shadow value of capital is not tied to the average price of capital. The model delivers higher and more volatile asset returns during recessions as well as a counter cyclical equity premium.

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