Limited Market Participation and Volatility of Asset Prices (Revision of 14-91) (Reprint 043)

Traditional theories of asset pricing assume there is a complete market participation, in the sense that all investors participate in all markets. In that case, preferences shocks typically have only a small effect on asset prices and are not an important determinant of asset price volatility. However, there is considerable empirical evidence that most investors participate in a limited number of markets. We show that limited market participation can amplify the effect of preference shocks, so that an arbitrarily small degree of aggregate uncertainty about preferences causes a large degree of price volatility. We also show there may exist Pareto-ranked equilibria, where the Pareto-preferred equilibrium is characterized by a different pattern of participation and lower volatility.