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," 2005 Meeting Papers 148, Society for Economic Dynamics.
- Karl Schmedders, 2005. "Two-Fund Separation in Dynamic General Equilibrium," Discussion Papers, Northwestern University, Center for Mathematical Studies in Economics and Management Science 1398, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
- 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; Trading Volume; Bond Interest Rates
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