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Two-fund separation in dynamic general equilibrium

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  • Schmedders, Karl

    ()
    (Kellogg School of Management)

Abstract

This paper examines the two-fund separation paradigm in the context of an infinite-horizon general equilibrium model with dynamically complete markets and heterogeneous consumers with time- and state-separable utility functions. With the exception of the dynamic structure, we maintain the assumptions of the classical static models that exhibit two-fund separation with a riskless security. Agents have equi-cautious HARA utility functions. In addition to a security with state-independent payoffs, agents can trade a collection of assets with dividends following a time-homogeneous Markov process. We make no further assumptions about the distribution of asset dividends, returns, or prices. If the riskless security in the economy is a consol then agents' portfolios exhibit two-fund separation. However, if agents can trade only a one-period bond, this result no longer holds. The underlying intuition is that general equilibrium restrictions lead to interest rate fluctuations that destroy the optimality of two-fund separation in economies with a one-period bond and result in different equilibrium portfolios.

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Bibliographic Info

Article provided by Econometric Society in its journal Theoretical Economics.

Volume (Year): 2 (2007)
Issue (Month): 2 (June)
Pages:

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Handle: RePEc:the:publsh:320

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Web page: http://econtheory.org

Related research

Keywords: Portfolio separation; dynamically complete markets; consol; one-period bond; interest rate fluctuation; reinvestment risk;

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References

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  1. CITANNA, Alessandro & POLEMARCHAKIS, Heracles M. & TIRELLI, M., 2000. "The Taxation of Trades in assets," Les Cahiers de Recherche 721, HEC Paris.
  2. Kenneth L. Judd & Felix Kubler & Karl Schmedders, 2000. "Asset Trading Volume with Dynamically Complete Markets and Heterogeneous Agents," Discussion Papers 1294, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  3. Russell, Thomas, 1980. "Portfolio separation : The analytic case," Economics Letters, Elsevier, vol. 6(1), pages 59-66.
  4. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  5. Peter Bossaerts & Charles Plott & William R. Zame, 2006. "Prices and Portfolio Choices in Financial Markets: Theory and Experiment," Levine's Bibliography 122247000000001322, UCLA Department of Economics.
  6. Amershi, Amin H & Stoeckenius, Jan H W, 1983. "The Theory of Syndicates and Linear Sharing Rules," Econometrica, Econometric Society, vol. 51(5), pages 1407-16, September.
  7. David Cass & Alessandro Citanna, 1998. "Pareto improving financial innovation in incomplete markets," Economic Theory, Springer, vol. 11(3), pages 467-494.
  8. Cass, David & Stiglitz, Joseph E., 1970. "The structure of investor preferences and asset returns, and separability in portfolio allocation: A contribution to the pure theory of mutual funds," Journal of Economic Theory, Elsevier, vol. 2(2), pages 122-160, June.
  9. Black, Fischer, 1972. "Capital Market Equilibrium with Restricted Borrowing," The Journal of Business, University of Chicago Press, vol. 45(3), pages 444-55, July.
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Cited by:
  1. Anufriev, Mikhail & Bottazzi, Giulio & Marsili, Matteo & Pin, Paolo, 2012. "Excess covariance and dynamic instability in a multi-asset model," Journal of Economic Dynamics and Control, Elsevier, vol. 36(8), pages 1142-1161.
  2. Chiaki Hara, 2006. "Heterogeneous Risk Attitudes In A Continuous-Time Model," The Japanese Economic Review, Japanese Economic Association, vol. 57(3), pages 377-405.

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