Model Uncertainty, Limited Market Participation, and Asset Prices

We demonstrate that limited market participation can arise endogenously in the presence of model uncertainty. Our model generates novel predictions on the relation between limited market participation, the equity premium, and the diversification discount. When the dispersion in investors’ model uncertainty is small, full market participation prevails in equilibrium. In this case, the equity premium is unrelated to the model uncertainty dispersion and a conglomerate trades at a price equal to the sum of its single segment counterparts. When the model uncertainty dispersion is large, however, some investors optimally choose to stay sidelined in equilibrium. In this case, the participation rate and the equity premium decrease with the model uncertainty dispersion. This is in sharp contrast to the understanding in the existing literature that limited market participation leads to higher equity premium and helps to resolve the equity premium puzzle. Moreover, when limited market participation occurs, a conglomerate trades at a discount relative to its single segment counterparts. The discount increases in model uncertainty dispersion and is positively related to the proportion of investors not partcipating in the markets. A conglomerate merger also reduces the proportion of market participants. Our finding offers a new explanantion for the diversification discount from the asset pricing perspective. ∗H. Henry Cao and Harold H. Zhang are with the Kenan-Flagler Business School, University of North Carolina, Chapel Hill, NC 27599-3490, USA, [email protected], [email protected]; and TanWang is with the Faculty of Commerce and Business Administration, University of British Columbia, Vancouver, British Columbia, Canada, V6T 1Z2, [email protected]. The authors are grateful to seminar participants at the economics department of the University of North Carolina at Chapel Hill and the finance group of the University of North Carolina at Charlotte, and University of California, Riverside for helpful comments. Tan Wang thanks the Social Sciences and Humanities Research Council of Canada for financial support.