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Multiplicity and Sunspots in General Financial Equilibrium with Portfolio Constraints

Author

Listed:
  • 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.

Suggested Citation

  • Suleyman Basak & David Cass & Juan Manuel Licari & Anna Pavlova, 2006. "Multiplicity and Sunspots in General Financial Equilibrium with Portfolio Constraints," PIER Working Paper Archive 06-012, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
  • Handle: RePEc:pen:papers:06-012
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    File URL: http://economics.sas.upenn.edu/system/files/working-papers/06-012.pdf
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    References listed on IDEAS

    as
    1. 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 309-341.
    2. 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.
    3. 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.
    4. Cass, David & Pavlova, Anna, 2004. "On trees and logs," Journal of Economic Theory, Elsevier, vol. 116(1), pages 41-83, May.
    5. Barlevy, Gadi & Veronesi, Pietro, 2003. "Rational panics and stock market crashes," Journal of Economic Theory, Elsevier, vol. 110(2), pages 234-263, June.
    6. Pavlova, Anna & Rigobon, Roberto, 2005. "Wealth Transfers, Contagion and Portfolio Constraints," CEPR Discussion Papers 5117, C.E.P.R. Discussion Papers.
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    13. 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 1133-1174.
    14. Jérôme Detemple & Angel Serrat, 2003. "Dynamic Equilibrium with Liquidity Constraints," Review of Financial Studies, Society for Financial Studies, vol. 16(2), pages 597-629.
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    Cited by:

    1. Jose M. Marin & Jacques P. Olivier, 2008. "The Dog That Did Not Bark: Insider Trading and Crashes," Journal of Finance, American Finance Association, vol. 63(5), pages 2429-2476, October.

    More about this item

    Keywords

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

    JEL classification:

    • D51 - Microeconomics - - General Equilibrium and Disequilibrium - - - Exchange and Production Economies
    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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