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.
Procedures for computing the parameters of a broad class of multifactor continuous time models of the term structure based on indirect estimation methods are proposed. The approach consists of simulating the unknown factors from a set of stochastic differential equations which are used to compute synthetic bond yields. The bond yields are calibrated with actual bond yields via an auxiliary model. The approach circumvents many of the difficulties associated with direct estimation of this class of models using maximum likelihood. In particular, the paper addresses the identification issues arising from singularities in the yields and spreads which tend not to be recognised in existing estimation procedures and thereby overcome potential misspecification problems inherrent in direct methods. Indirect estimates of single and multifactor models are computed and compared with the estimates based on existing estimation procedures.
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.
Traditional theories of asset pricing assume there is complete market participation so all investors participate in all markets. In this case changes in preferences typically have only a small effect on asset prices and are not an important determinant of asset price volatility. However, there is considerable empirical evidence that most investors participate in a limited number of markets. We show that limited market participation can amplify the effect of changes in preferences so that an arbitrarily small degree of aggregate uncertainty in preferences can cause a large degree of price volatility. We also show that in addition to this equilibrium with limited participation and volatile asset prices, there may exist a Pareto-preferred equilibrium with complete participation and less volatility.
We describe a stochastic economic environment in which the mix of money and trade credit used as means of payment is endogenous. The economy has an infinite horizon, spatial separation and a credit-related transaction cost, but no capital. We find that the equilibrium prices of arbitrary contingent claims to future currency differ from those from one-good cash-in-advance models. This anomaly is directly related to the endogeneity of the mix of media of exchange used. In particular, nominal interest rates affect the risk-free real rate of return. The model also has implications for some long-standing issues in monetary policy and for time series analysis using money and trade credit.