Intertemporal Consumption Choices, Transaction Costs and Limited Participation in Financial Markets: Reconciling Data and Theory

This paper builds a unifying framework based on the theory of intertemporal consumption choices that brings together the limited participation-based explanation of the C-CAPM poor empirical per- formance and the transaction costs-based explanation of incomplete portfolios. Using the implications of the consumption model and ob- served household consumption and portfolio choices, we identify the preference parameters of interest and a lower bound for the costs ra- tionalizing non-participation in …nancial markets. Using the US Con- sumer Expenditure Survey and assuming isoelastic preferences, we es- timate the coe¢ cient of relative risk aversion at 1.7 and a cost bound of 0.4 percent of non-durable consumption. Our estimate of the pref- erence parameter is theoretically plausible and the bound su¢ ciently small to be likely to be exceeded by the actual total (observable and unobservable) costs of participating in …nancial markets.