Two-fund separation in dynamic general equilibrium
AbstractThis 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 InfoArticle provided by Econometric Society in its journal Theoretical Economics.
Volume (Year): 2 (2007)
Issue (Month): 2 (June)
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Web page: http://econtheory.org
Portfolio separation; dynamically complete markets; consol; one-period bond; interest rate fluctuation; reinvestment risk;
Other versions of this item:
- Karl Schmedders, 2005. "Two-Fund Separation in Dynamic General Equilibrium," Discussion Papers 1398, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
- Karl Schmedders, 2005. "Two-Fund Separation in Dynamic General Equilibrium," 2005 Meeting Papers 148, Society for Economic Dynamics.
- D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
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