Borrowing Costs and the Demand for Equity over the Life Cycle

Abstract

We construct a life cycle model that delivers realistic behavior for both equity holdings and borrowing. 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. Copyright by the President and Fellows of Harvard College and the Massachusetts Institute of Technology.