Preprint C6/2002
Infinite Horizon Incomplete Markets: Equilibrium, Default and Bubbles.
Juan Pablo Torres Martinez
Keywords: Equilibrium | Collateral | Multiperiod Assets | Transversality Conditions | Asset Pricing Bubbles.
In an infinite-horizon sequential economy, we study a general equilibrium model with financial assets which are subject to default. We model default through exogenous collateral requirements, which are demanded from the borrowers for each unit sold by them. We base this model on the two-period economy with default introduced by Dubey, Geanakoplos, and Zame (1995). In the case of markets which allow only short-lived assets, we show that equilibrium always exists, without introducing either transversality conditions or debts constraints to avoid the possibility of Ponzi schemes. We extend the previous result to the case of long-lived assets and address existence of equilibrium in a very general context, where we allow incomplete participation of the agents and both physical and financial collateral requirements. Within this last scenario we study the occurrence of speculation in the prices of durable goods and assets. The fact that assets subject to default may be regarded as derivatives, whose underlying assets are those securities that are used as collateral requirements, allows us to show that asset price bubbles are caused by bubbles in the prices of durable goods and of default-free assets. We also obtain sufficient conditions for the non-existence of speculation in the markets.