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RFS Advance Access originally published online on August 31, 2005
Review of Financial Studies 2005 18(4):1219-1251; doi:10.1093/rfs/hhi034
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© The Author 2005. Published by Oxford University Press. All rights reserved. For Permissions, please email: journals.permissions@oupjournals.org

Model Uncertainty, Limited Market Participation, and Asset Prices

H. Henry Cao
Cheung Kong Graduate School of Business

Tan Wang
Sauder School of Business, University of British Columbia and CCFR

Harold H. Zhang
School of Management, University of Texas at Dallas

Address correspondence to H. Henry Cao, Cheung Kong Graduate School of Business, Oriental Plaza 3/F, Tower E3, 1 East Chang An Avenue, Beijing 100738, PR China, or e-mail: hncao{at}ckgsb.edu.cn

We demonstrate that limited participation can arise endogenously in the presence of model uncertainty and heterogeneous uncertainty-averse investors. When uncertainty dispersion among investors is small, full participation prevails in equilibrium. Equity premium is related to the average uncertainty among investors and a conglomerate trades at a price equal to the sum of its single-segment components. When uncertainty dispersion is large, investors with high uncertainty choose not to participate in the stock market, resulting in limited market participation. When limited participation occurs, participation rate and equity premium can decrease in uncertainty dispersion and a conglomerate trades at a discount.


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