Working paper (Federal Reserve Bank of Minneapolis. Research Dept.)
Previous work on discrete time portfolio selection models encompassed (a) transaction's costs, and (b) uncertainty about cash flows during the first (and only) period. This paper extends these models by considering uncertainty about asset yields in the second period and the optimal strategy for portfolio selection over a two-period horizon. Among the implications are i) the optimal initial portfolio is, in general, diversified and contains more short-term assets than the myopic investor's portfolio, and ii) the shape of the mean-variance locus ensures diversification for all (two-moment) types of investors, except certain forms of risk lovers. Other partial derivatives are investigated.
Working paper 6 is based largely on chapter 3 of Supel's University of Minnesota Ph.D. dissertation, "A two-period balance sheet model for banks."
This paper studies efficient insurance arrangements in village economies when there is complete information but limited commitment. Commitment is limited because only limited penalties can be imposed on households which renege on their promises. Any efficient insurance arrangement must therefore take into account the fact that households will renege if the benefits from doing so outweigh the costs. We study a general model which admits aggregate and idiosyncratic risk as well as serial correlation of incomes. It is shown that in the case of two households and no storage the efficient insurance arrangement is characterized by a simple updating rule. An example illustrates the similarity of the efficient arrangement to a simple debt contract with occasional debt forgiveness. The model is then extended to multiple households and a simple storage technology. We use data from the ICRISAT survey of three villages in southern India to test the theory against three alternative models: autarky, full insurance, and a static model of limited commitment due to Coate and Ravallion (1993). Overall, the model we develop does a significantly better job of explaining the data than does any of these alternatives.