Borrowing Costs and the Demand for Equity over the Life Cycle
Working
Paper 05-7
by Steven J. Davis, Felix Kubler, and Paul Willen
2005 Series
We construct a life-cycle model that delivers realistic behavior for both equity holdings and borrowings. The key model ingredient is a wedge between the cost of borrowing and the risk-free investment return. Borrowing can either raise or lower equity demand, depending on the cost of borrowing. A borrowing rate equal to the expected return on equity — which we show roughly matches the data — minimizes the demand for equity. Alternative models with no borrowing or limited borrowing at the risk-free rate cannot simultaneously fit empirical evidence on borrowing and equity holdings.
JEL classification codes: D91, G11
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