Asset Prices in a Heterogenous-Agent Economy with Portfolio Constraints∗

Our objective in this article is to study analytically the effect of borrowing constraints on asset returns in an economy where agents are heterogenous with respect to their risk aversion. We use asymptotic analysis to characterize the equilibrium in a general equilibrium exchange economy with an arbitrary number of agents who differ in their risk aversion and face limits on borrowing. We find that in the unconstrained economy the volatility of stock returns increases with the second moment of the cross-sectional distribution of risk aversion, while the risk-free rate and the equity premium are affected primarily by the first moment of the cross-sectional distribution of risk aversion. Limiting borrowing reduces the volatility of stock returns, lowers the risk-free interest rate and increases the equity risk premium. The method used for characterizing the equilibrium analytically applies also to other settings with a stochastic investment opportunity set and incomplete financial markets. JEL classification: G12, G11, D52, C63.