Heterogeneous Preferences, Constraints, and the Cyclicality of Leverage

This paper solves an open problem in financial mathematics by characterizing the equilibrium in a continuous time financial market populated by heterogeneous agents who differ in their rate of relative risk aversion and face... [ view full abstract ]

This paper solves an open problem in financial mathematics by characterizing the equilibrium in a continuous time financial market populated by heterogeneous agents who differ in their rate of relative risk aversion and face convex portfolio constraints. The model is studied in an application to margin constraints. It is shown how margin constraints increase the market price of risk and decrease the interest rate, producing a higher equity risk premium. In addition, heterogeneity and margin constraints are shown to produce both pro- and counter-cyclical leverage cycles. This ambiguity of the leverage cycle is then documented empirically.