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Two-Fund Separation in Dynamic General Equilibrium

  • Karl Schmedders

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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Paper provided by Northwestern University, Center for Mathematical Studies in Economics and Management Science in its series Discussion Papers with number 1398.

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Date of creation: Jan 2005
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Handle: RePEc:nwu:cmsems:1398
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  1. David Cass & Alessandro Citanna, 1998. "Pareto improving financial innovation in incomplete markets," Economic Theory, Springer, vol. 11(3), pages 467-494.
  2. Russell, Thomas, 1980. "Portfolio separation : The analytic case," Economics Letters, Elsevier, vol. 6(1), pages 59-66.
  3. 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.
  4. Black, Fischer, 1972. "Capital Market Equilibrium with Restricted Borrowing," The Journal of Business, University of Chicago Press, vol. 45(3), pages 444-55, July.
  5. Peter Bossaerts & Charles Plott & William R. Zame, 2005. "Prices and Portfolio Choices in Financial Markets: Theory and Experiments," UCLA Economics Working Papers 840, UCLA Department of Economics.
  6. 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.
  7. 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.
  8. Citanna, A. & Polemarchakis, H.M. & Tirelli, M., 2006. "The taxation of trades in assets," Journal of Economic Theory, Elsevier, vol. 126(1), pages 299-313, January.
  9. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  10. repec:hal:journl:hal-00479286 is not listed on IDEAS
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