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Multiplicity and Sunspots in General Financial Equilibrium with Portfolio Constraints

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Author Info

  • Suleyman Basak

    ()
    (London Business School and CEPR)

  • David Cass

    ()
    (Department of Economics, University of Pennsylvania)

  • Juan Manuel Licari

    ()
    (Department of Economics, University of Pennsylvania)

  • Anna Pavlova

    ()
    (London Business School and CEPR)

Abstract

This paper explores the role of portfolio constraints in generating multiplicity of equilibrium. We present a simple asset market economy with two goods and two households, households who face constraints on their ability to take unbounded positions in risky stocks. Absent such constraints, equilibrium allocation is unique and is Pareto efficient. With a single portfolio constraint in place, the efficient equilibrium is still possible; however, additional inefficient equilibria in which the constraint is binding may emerge. We show further that with sunspots, there may be a continuum of equilibria; sunspots may lead to real indeterminacy. Extending our analysis of sunspot phenomena to three periods, we show that our model is also capable of generating moves in stock prices unrelated to so-called fundamentals; such movements are triggered purely by sunspots which only affect investors'(rational) expectations about future market behavior. This provides a simple, coherent explanation for the apparent inability of empirical studies to link many sharp price movements in stock markets to news about economic fundamentals.

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Bibliographic Info

Paper provided by Penn Institute for Economic Research, Department of Economics, University of Pennsylvania in its series PIER Working Paper Archive with number 06-012.

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Length: 46 pages
Date of creation: 01 Jun 2006
Date of revision:
Handle: RePEc:pen:papers:06-012

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Keywords: asset pricing; portfolio constraints; financial equilibrium; multiple equilibrium; sunspots; intrinsic and extrinsic uncertainty;

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References

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  1. Pavlova, Anna & Cass, David, 2002. "On Trees and Logs," Working papers 4233-02, Massachusetts Institute of Technology (MIT), Sloan School of Management.
  2. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  3. Jérôme B. Detemple & Shashidhar Murthy, 1997. "Equilibrium Asset Prices and No-Arbitrage with Portfolio Constraints," CIRANO Working Papers 97s-12, CIRANO.
  4. Basak, Suleyman & Cuoco, Domenico, 1998. "An Equilibrium Model with Restricted Stock Market Participation," Review of Financial Studies, Society for Financial Studies, vol. 11(2), pages 309-41.
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  7. Duffie, Darrell & Shafer, Wayne, 1985. "Equilibrium in incomplete markets: I : A basic model of generic existence," Journal of Mathematical Economics, Elsevier, vol. 14(3), pages 285-300, June.
  8. Gerard Gennotte and Hayne Leland., 1989. "Market Liquidity, Hedging and Crashes," Research Program in Finance Working Papers RPF-192, University of California at Berkeley.
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  10. Roll, Richard, 1984. "Orange Juice and Weather," American Economic Review, American Economic Association, vol. 74(5), pages 861-80, December.
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  12. Jérôme Detemple & Angel Serrat, 2003. "Dynamic Equilibrium with Liquidity Constraints," Review of Financial Studies, Society for Financial Studies, vol. 16(2), pages 597-629.
  13. Harrison Hong & Jeremy C. Stein, 2003. "Differences of Opinion, Short-Sales Constraints, and Market Crashes," Review of Financial Studies, Society for Financial Studies, vol. 16(2), pages 487-525.
  14. Barlevy, Gadi & Veronesi, Pietro, 2003. "Rational panics and stock market crashes," Journal of Economic Theory, Elsevier, vol. 110(2), pages 234-263, June.
  15. Cass, David & Siconolfi, Paolo & Villanacci, Antonio, 2001. "Generic regularity of competitive equilibria with restricted participation," Journal of Mathematical Economics, Elsevier, vol. 36(1), pages 61-76, September.
  16. Detemple, Jerome & Murthy, Shashidhar, 1997. "Equilibrium Asset Prices and No-Arbitrage with Portfolio Constraints," Review of Financial Studies, Society for Financial Studies, vol. 10(4), pages 1133-74.
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Cited by:
  1. Marín Vigueras, José Maria & Olivier, Jacques, 2007. "The Dog that Did Not Bark: Insider Trading and Crashes," CEPR Discussion Papers 6244, C.E.P.R. Discussion Papers.

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