LIMITED MARKET PARTICIPATION AND VOLATILITY OF ASSET PRICES

Traditional asset-pricing theories assume complete market participatio n, despite considerable empirical evidence that most investors partici pate in a limited number of markets. We show that once the participati on decision is endogenized, market properties change dramatically. Fir st, limited market participation can amplify the effect of liquidity t rading relative to full participation; under certain circumstances, an arbitrarily small aggregate liquidity shock can cause significant pri ce volatility. Second, there exist multiple equilibria with very diffe rent participation regimes and levels of asset-price volatility. Third , under plausible conditions the equilibria can be Pareto-ranked; the Pareto-preferred equilibrium is characterized by greater participation and lower volatility.