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Two-Fund Separation in Dynamic General Equilibrium

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  • Karl Schmedders

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.

Suggested Citation

  • Karl Schmedders, 2005. "Two-Fund Separation in Dynamic General Equilibrium," Discussion Papers 1398, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  • Handle: RePEc:nwu:cmsems:1398
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    References listed on IDEAS

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    Cited by:

    1. Anufriev, Mikhail & Bottazzi, Giulio & Marsili, Matteo & Pin, Paolo, 2012. "Excess covariance and dynamic instability in a multi-asset model," Journal of Economic Dynamics and Control, Elsevier, vol. 36(8), pages 1142-1161.
    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, September.
    3. Won, Dong Chul, 2018. "One-fund separation in incomplete markets with two assets," Finance Research Letters, Elsevier, vol. 24(C), pages 168-174.

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    More about this item

    JEL classification:

    • 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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