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A General Equilibrium Financial Asset Economy with Transaction Costs and Trading Constraints

  • Frank Milne

    ()

    (Queen's University)

  • Edwin Neave

    (Queen's University)

This paper presents a unified framework for examining the general equilibrium effects of transactions costs and trading constraints on security market trades and prices. The model uses a discrete time/state framework and Kuhn-Tucker theory to characterize the optimal decisions of consumers and financial intermediaries. Transaction costs and constraints give rise to regions of no trade and to bid-ask spreads: their existence frustrate the derivation of standard results in arbitrage-based pricing. Nevertheless, we are able to obtain as dual characterizations of our primal problems, one-sided arbitrage pricing results and a personalized martingale representation of asset pricing. These pricing results are identical to those derived by Jouini and Kallal (1995) using arbitrage arguments. The paper's framework incorporates a number of specialized existing models and results, proves new results and discusses new directions for research. In particular, we include characterizations of intermediaries who hold optimal portfolios; brokers who do not hold portfolios, and consumer-specific transactions costs and trading constraints. Furthermore we show that in the special case of equiproportional transaction costs and a sufficient number of assets, there is an analogue of the arbitrage pricing result for European derivatives where prices are interpreted as mid-prices between the bid-ask spread. We discuss the effects of non-convex transaction technologies on prices and trades.

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File URL: http://qed.econ.queensu.ca/working_papers/papers/qed_wp_1082.pdf
File Function: First version 2003
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Paper provided by Queen's University, Department of Economics in its series Working Papers with number 1082.

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Length: 44 pages
Date of creation: Sep 2003
Date of revision:
Handle: RePEc:qed:wpaper:1082
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  1. Epstein, Larry G & Wang, Tan, 1994. "Intertemporal Asset Pricing Under Knightian Uncertainty," Econometrica, Econometric Society, vol. 62(2), pages 283-322, March.
  2. Heller, Walter Perrin & Starr, Ross M, 1976. "Equilibrium with Non-convex Transactions Costs: Monetary and Non-monetary Economies," Review of Economic Studies, Wiley Blackwell, vol. 43(2), pages 195-215, June.
  3. Anthony W. Lynch & Pierluigi Balduzzi, 2000. "Predictability and Transaction Costs: The Impact on Rebalancing Rules and Behavior," Journal of Finance, American Finance Association, vol. 55(5), pages 2285-2309, October.
  4. Madan, Dilip & Soubra, Badih, 1991. "Design and Marketing of Financial Products," Review of Financial Studies, Society for Financial Studies, vol. 4(2), pages 361-84.
  5. Cox, John C. & Ross, Stephen A. & Rubinstein, Mark, 1979. "Option pricing: A simplified approach," Journal of Financial Economics, Elsevier, vol. 7(3), pages 229-263, September.
  6. Machina, Mark J, 2000. "Payoff Kinks in Preferences Over Lotteries," University of California at San Diego, Economics Working Paper Series qt7vn7d2hs, Department of Economics, UC San Diego.
  7. Xing Jin & Frank Milne, 1996. "The Existence of Equilibrium in a Financial Market with Transaction Costs," Working Papers 934, Queen's University, Department of Economics.
  8. Milne, Frank & Shefrin, H. M., 1987. "Information and securities: A note on pareto dominance and the second best," Journal of Economic Theory, Elsevier, vol. 43(2), pages 314-328, December.
  9. Jaime Cuevas Dermody & R. Tyrrell Rockafellar, 1995. "Tax Basis And Nonlinearity In Cash Stream Valuation," Mathematical Finance, Wiley Blackwell, vol. 5(2), pages 97-119.
  10. George M. Constantinides, 1979. "Multiperiod Consumption and Investment Behavior with Convex Transactions Costs," Management Science, INFORMS, vol. 25(11), pages 1127-1137, November.
  11. Turunen-Red, Arja H & Woodland, Alan D, 1991. "Strict Pareto-Improving Multilateral Reforms of Tariffs," Econometrica, Econometric Society, vol. 59(4), pages 1127-52, July.
  12. Machina, Mark J, 2001. " Payoff Kinks in Preferences over Lotteries," Journal of Risk and Uncertainty, Springer, vol. 23(3), pages 207-60, November.
  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 1133-74.
  14. Elul Ronel, 1995. "Welfare Effects of Financial Innovation in Incomplete Markets Economies with Several Consumption Goods," Journal of Economic Theory, Elsevier, vol. 65(1), pages 43-78, February.
  15. Jérôme B. Detemple & Shashidhar Murthy, 1997. "Equilibrium Asset Prices and No-Arbitrage with Portfolio Constraints," CIRANO Working Papers 97s-12, CIRANO.
  16. Milne, Frank, 1981. "Induced preferences and the theory of the consumer," Journal of Economic Theory, Elsevier, vol. 24(2), pages 205-217, April.
  17. Heath, David & Jarrow, Robert & Morton, Andrew, 1992. "Bond Pricing and the Term Structure of Interest Rates: A New Methodology for Contingent Claims Valuation," Econometrica, Econometric Society, vol. 60(1), pages 77-105, January.
  18. Edirisinghe, Chanaka & Naik, Vasanttilak & Uppal, Raman, 1993. "Optimal Replication of Options with Transactions Costs and Trading Restrictions," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 28(01), pages 117-138, March.
  19. Jaime Cuevas Dermody & R. Tyrrell Rockafellar, 1991. "Cash Stream Valuation In the Face of Transaction Costs and Taxes," Mathematical Finance, Wiley Blackwell, vol. 1(1), pages 31-54.
  20. Duffie, Darrell, 1990. "Money in general equilibrium theory," Handbook of Monetary Economics, in: B. M. Friedman & F. H. Hahn (ed.), Handbook of Monetary Economics, edition 1, volume 1, chapter 3, pages 81-100 Elsevier.
  21. repec:fth:inseep:9513 is not listed on IDEAS
  22. Kelsey, David & Milne, Frank, 1999. "Induced Preferences, Nonadditive Beliefs, and Multiple Priors," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 40(2), pages 455-77, May.
  23. Joseph M. Ostroy & Ross M. Starr, 1988. "The Transactions Role of Money," UCLA Economics Working Papers 505, UCLA Department of Economics.
  24. Milne, Frank & Smith, Clifford W., 1980. "Capital Asset Pricing with Proportional Transaction Costs," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 15(02), pages 253-266, June.
  25. Edwin H. Neave, 1970. "The Stochastic Cash Balance Problem with Fixed Costs for Increases and Decreases," Management Science, INFORMS, vol. 16(7), pages 472-490, March.
  26. Radner, Roy, 1972. "Existence of Equilibrium of Plans, Prices, and Price Expectations in a Sequence of Markets," Econometrica, Econometric Society, vol. 40(2), pages 289-303, March.
  27. Constantinides, George M, 1986. "Capital Market Equilibrium with Transaction Costs," Journal of Political Economy, University of Chicago Press, vol. 94(4), pages 842-62, August.
  28. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July.
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  30. 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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  33. Dermody, Jaime Cuevas & Prisman, Eliezer Zeev, 1988. " Term Structure Multiplicity and Clientele in Markets with Transactions Costs and Taxes," Journal of Finance, American Finance Association, vol. 43(4), pages 893-911, September.
  34. Jouini Elyes & Kallal Hedi, 1995. "Martingales and Arbitrage in Securities Markets with Transaction Costs," Journal of Economic Theory, Elsevier, vol. 66(1), pages 178-197, June.
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