Working Paper: CEPR ID: DP7138
Authors: Bernard J. Dumas; Andrew Lyasoff
Abstract: We develop a method that allows one to compute incomplete-market equilibria routinely for Markovian equilibria (when they exist). The main difficulty to be overcome arises from the set of state variables. There are, of course, exogenous state variables driving the economy but, in an incomplete market, there are also endogenous state variables, which introduce path dependence. We write on an event tree the system of all first-order conditions of all times and states and solve recursively for state prices, which are dual variables. We illustrate this ?dual? method and show its many practical advantages by means of several examples.
Keywords: Computation; Financial Market Equilibrium; Incomplete Market; Recursive Methods
JEL Codes: C63; C68; D52; D58; D91; G11; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| endogenous state variables (C51) | path dependence in state prices and consumption decisions (D11) |
| recursive method (C69) | computation of equilibria in Markovian settings (C62) |
| recursive algorithm (C69) | computational advantages over traditional dynamic programming approaches (C61) |
| missing-market risks (G19) | impact on traded markets (F69) |
| missing-market risks (G19) | increase in risk premia and volatility (G19) |