Abstract not found

Modern finance has generated a set of formal models of the workings of financial markets that certainly excel in terms of mathematical elegance. But abstract beauty and logical appeal do not guarantee scientific validity. The illustrious late Richard Feynman, professor of physics at Caltech, made the same observation when he discussed the derivation of the law of gravitational potential energy from the "axiom" of conservation of energy. (See the above quote.) Fortunately for physicists, there is ample evidence that the law of gravitational potential energy is correct (to a certain degree). In contrast, there appears to be surprisingly little scientific support for even the most widely used financial model, namely, the CAPM. One can sympathize with E. Fama and K. French when they have recently begun to promote a pricing model that is based entirely on statistical regularities, even if it begs the question why it is more successful. To put this di#erently, asset pricing is paradoxical

We extend the standard model of general equilibrium with incomplete markets to allow for default and punishment. The equilibrating variables include expected delivery rates, along with the usual prices of assets and commodities. By reinterpreting the variables, our model encompasses a broad range of adverse selection and signalling phenomena (including the Akerlof lemons model and the Rothschild—Stiglitz insurance model) in a general equilibrium framework. Despite earlier claims about the nonexistence of equilibrium with adverse selection, we show that equilibrium always exists. We show that more lenient punishment which encourages default may be Pareto improving because it increases the dimension of the asset span without increasing the number of assets traded. We deÞne an equilibrium reÞnement that requires expected delivery rates for untraded assets to be reasonably optimistic. Default, in conjunction with this reÞnement, opens the door to a theory of endogenous assets. The market chooses the promises, default penalties, and quantity constraints of actively traded assets.

Consider the postage stamp. As title to a future good (or, in this case, service) with monetary value, this humble object is essentially the same as a security. Its value, 37 cents, can be identiÞed with the present value of the service (delivery of a letter) to which its owner is entitled.

This paper compares the equilibrium allocations of a stochastic economy induced by two market structures: contingent markets and a sequential system of spot and real asset markets. We exhibit a regularity condition on the asset structure which we prove to be a necessary and sufficient condition for the equilibrium allocations for the two market structures to coincide generically. 1.

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The recent economic crisis highlights the role of financial markets in allowing economic agents, including prominent banks, to speculate on the future returns of different financial assets, such as mortgage-backed securities. This paper introduces a dynamic general equilibrium model with aggregate shocks, potentially incomplete markets and heterogeneous agents to investigate this role of financial markets. In addition to their risk aversion and endowments, agents differ in their beliefs about the future aggregate states of the economy. The difference in beliefs induces them to take large bets under frictionless complete financial markets, which enable agents to leverage their future wealth. Consequently, as hypothesized by Friedman (1953), under complete markets, agents with incorrect beliefs will eventually be driven out of the markets. In this case, they also have no influence on asset prices and real investment in the long run. In contrast, I show that under incomplete markets generated by collateral constraints, agents with heterogeneous (potentially incorrect) beliefs survive in the long run and their speculative activities drive up asset price volatility and real investment volatility permanently. I also show that collateral constraints are always binding even if the supply of collateralizable assets endogenously responds to their price. I use this framework to study the e¤ects of di¤erent types of regulations and the distribution of endowments on leverage, asset price volatility and investment. Lastly, the analytical tools developed in this framework enable me to prove the existence of the recursive equilibrium in Krusell and Smith (1998) with a finite number of types. This has been an open question in the literature.

Presidential address for the Twelfth World Congress of the International Economic Association, summarising semi-formally the author's recent work and concerns. Uncertainty and incomplete markets breed demand volatility as well as price and wage rigidities. The conjunction of these leads to multiple, volatile supply-constrained equilibria, typically reflecting coordination failures and apt to display persistence- as documented by three supporting theorems. Specific implications are linked to the conclusions that we should take coordination failures seriously, try to obviate demand volatility and try to bypass price and wage rigidities.

Summary. We review the issues related to the formulation of endogenous uncertainty in rational belief equilibria(RBE). In all previous models of RBE, individual states of belief were the foundation for the construction of the endogenous state space where individual states of belief were described with the method of assessment variables. This approach leads to a lack of "anonymity " where the belief of each individual agent has an impact on equilibrium prices but as a competitor he ignores it. The solution is to study a replica economy with a finite number of types but with a large number of agents of each type. This gives rise to "type-states " which are distributions of beliefs within each type. The state space for this economy is then constructed as the set of products of the exogenous states and the social states of belief which are vectors of distributions of all the types. Such an economy leads to RBE which do indeed solve the problem of anonymity. We then study via simulations the implications of the model of RBE with social states for market volatility and for the determinants of the equity risk premium in an RBE. Under i.i.d. assessments one uses the law of large numbers to induce a single social state of belief and we show that the RBE of such economies have the same number of prices as in rational expectations equilibrium (REE). However, the RBE may exhibit large fluctuations if agents are allowed to hold extreme beliefs. Establishing 5 % boundary restrictions on beliefs we show that the model with a single social state of belief

According to the folk history of transaction costs, the concept is due to a seminal article by Ronald H. Coase, written in the 1930s. Failing to provide an operational framework, Coase’s article was neglected for a long time, or so the story continues. 1 In the 1970s, after the limits of the Arrow-Debreu paradigm