Creator: Alvarez, Fernando, 1964- and Jermann, Urban J. Series: Endogenous incompleteness Abstract:
We study the asset pricing implications of a multi-agent endowment economy where agents can default on debt. We build on the environment studied by Kocherlakota (1995) and Kehoe and Levine (1993). We present an equilibrium concept for an economy with complete markets and with endogenous solvency constraints. These solvency constraints prevent default, but at the cost of reduced risk sharing. We show that versions of the classical welfare theorems hold for this equilibrium definition. We characterize the pricing kernel, and compare it to the one for economies without participation constraints: interest rates are lower and risk premia depend on the covariance of the idiosyncratic and aggregate shocks.
Keyword: Equilibrium, Default, Solvency constraints, Risk, Shocks, and Assets Subject (JEL): G12 - General financial markets - Asset pricing ; Trading volume ; Bond interest rates and D50 - General equilibrium and disequilibrium - General
Creator: Ostroy, Joseph M. and Potter, Simon M. Series: Finance, fluctuations, and development Abstract:
We formulate a representative consumer model of intertemporal resource reallocation in which fluctuations in equity prices contribute to the smoothing of consumption flows. Features of the model include (a) an incompletely observable stochastic process of productivity shocks leading to fluctuating confidence of beliefs and (b) technologies involving commitments of a resource good. These features are exploited to show that (1) equities are not a representative form of total wealth and (2) the valuation of currently active firms is not representative of the valuation of all firms. We examine the implications of (1) and (2) to argue that empirical findings for the volatility and 'value shortfall' of equity prices may be consistent with a frictionless representative consumer model having a low degree of risk-aversion. Simulation of a calibrated version of the model for a risk-neutral consumer shows that when the 'data' is analyzed according to current econometric procedures, it is found to exhibit volatility of the same order of magnitude as that found in the actual data, although the model contains no excess volatility.
Keyword: Technological commitments, Equity premium, Uncertainty of beliefs, Excess volatility, and Value shortfall Subject (JEL): G12 - General financial markets - Asset pricing ; Trading volume ; Bond interest rates, E44 - Money and interest rates - Financial markets and the macroeconomy, G14 - General financial markets - Information and market efficiency ; Event studies, and E13 - General aggregative models - Neoclassical