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Two-Fund Separation in Dynamic General Equilibrium

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  • Karl Schmedders

    ()
    (MEDS Kellogg School of Management)

Abstract

The purpose of this paper is to examine 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. In addition to a se- curity 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. Agents have equi-cautious HARA utility functions. If the riskless security in the economy is a consol then agents' portfolios exhibit two-fund separation. But if agents can trade only a one-period bond, this result no longer holds. Examples show this effect to be quantitatively signifcant. The underly- ing intuition is that general equilibrium restrictions lead to interest rate °uctuations 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

Paper provided by Society for Economic Dynamics in its series 2005 Meeting Papers with number 148.

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Date of creation: 2005
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Handle: RePEc:red:sed005:148

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  1. Black, Fischer, 1972. "Capital Market Equilibrium with Restricted Borrowing," The Journal of Business, University of Chicago Press, vol. 45(3), pages 444-55, July.
  2. Kenneth L. Judd & Felix Kubler & Karl Schmedders, 2003. "Asset Trading Volume with Dynamically Complete Markets and Heterogeneous Agents," Journal of Finance, American Finance Association, vol. 58(5), pages 2203-2218, October.
  3. CITANNA, Alessandro & POLEMARCHAKIS, Heracles M. & TIRELLI, M., 2000. "The Taxation of Trades in assets," Les Cahiers de Recherche 721, HEC Paris.
  4. 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.
  5. 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.
  6. Russell, Thomas, 1980. "Portfolio separation : The analytic case," Economics Letters, Elsevier, vol. 6(1), pages 59-66.
  7. 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.
  8. David Cass & Alessandro Citanna, 1998. "Pareto improving financial innovation in incomplete markets," Economic Theory, Springer, vol. 11(3), pages 467-494.
  9. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
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Cited by:
  1. Anufriev, M. & Bottazzi, G. & Marsili, M. & Pin, P., 2011. "Excess Covariance and Dynamic Instability in a Multi-Asset Model," CeNDEF Working Papers 11-09, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance.
  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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