Working Paper: NBER ID: w14629
Authors: Bernard 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: Incomplete Markets; Equilibria; Event Tree; Markovian Equilibria; Financial Markets
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 |
|---|---|
| missing market risks (G10) | increased risk premia (G19) |
| missing market risks (G10) | increased volatility (E32) |
| missing market risks (G10) | deviations in the distribution of wealth among investors (D39) |
| structure of financial markets (G10) | ability to compute equilibria (C62) |
| incomplete market equilibria (D52) | influence asset pricing (G19) |
| incomplete market equilibria (D52) | risk-sharing among investors (G11) |