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The Optimal Price of Default

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Author Info

  • Wei Ma

    (Deptartment of manufacturing Engineering & Engineering Management, City University of Hong Kong)

  • Chuangyin Dang

    (Deptartment of manufacturing Engineering & Engineering Management, City University of Hong Kong)

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    Abstract

    With assets taken to be pools, rational expectations on their delivery rates are, as default is permissible in an economy and its penalty prescribed in terms of utility, indispensable to the existence of equilibrium. And the resulting equilibrium relies heavily on the prevailing penalty level. We propose, in this paper, a path-following algorithm for calculating the level of penalty that leads to a Pareto efficient equilibrium—Pareto efficient among the set of equilibria of the economies with distinct penalty levels. This algorithm brings off those rational expectations by identifying their upper and lower bounds iteratively until the discrepancies between them are admissible.

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    Bibliographic Info

    Article provided by Society for AEF in its journal Annals of Economics and Finance.

    Volume (Year): 14 (2013)
    Issue (Month): 1 (May)
    Pages: 145-167

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    Handle: RePEc:cuf:journl:y:2013:v:14:i:1:ma:dang

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    Related research

    Keywords: Default; Penalty; Path-following; Pareto efficiency; Rational expectation;

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    References

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    1. Oliver Hart & John Moore, 1997. "Default and Renegotiation: A Dynamic Model of Debt," STICERD - Theoretical Economics Paper Series /1997/321, Suntory and Toyota International Centres for Economics and Related Disciplines, LSE.
    2. Gale, Douglas & Hellwig, Martin, 1985. "Incentive-Compatible Debt Contracts: The One-Period Problem," Review of Economic Studies, Wiley Blackwell, vol. 52(4), pages 647-63, October.
    3. Eaves, B. Curtis & Schmedders, Karl, 1999. "General equilibrium models and homotopy methods," Journal of Economic Dynamics and Control, Elsevier, vol. 23(9-10), pages 1249-1279, September.
    4. Pradeep Dubey & John Geanakoplos & Martin Shubik, 2001. "Default and Punishment in General Equilibrium," Cowles Foundation Discussion Papers 1304R5, Cowles Foundation for Research in Economics, Yale University, revised Mar 2004.
    5. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, vol. 51(3), pages 393-414, July.
    6. Hart, Oliver D., 1975. "On the optimality of equilibrium when the market structure is incomplete," Journal of Economic Theory, Elsevier, vol. 11(3), pages 418-443, December.
    7. Brown, Donald J & DeMarzo, Peter M & Eaves, B Curtis, 1996. "Computing Equilibria When Asset Markets Are Incomplete," Econometrica, Econometric Society, vol. 64(1), pages 1-27, January.
    8. Junfeng Qiu, 2011. "Bank money, aggregate liquidity, and asset prices," Annals of Economics and Finance, Society for AEF, vol. 12(2), pages 295-346, November.
    9. Smale, Steve, 1976. "A convergent process of price adjustment and global newton methods," Journal of Mathematical Economics, Elsevier, vol. 3(2), pages 107-120, July.
    10. Cheng-si Zhang & Da-yin Zhang & Jeffery Breece, 2011. "Financial Crisis, Monetary Policy, and Stock Market Volatility in China," Annals of Economics and Finance, Society for AEF, vol. 12(2), pages 371-388, November.
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