Two-Fund Separation in Dynamic General Equilibrium

Karl Schmedders

No 1398, Discussion Papers from Northwestern University, Center for Mathematical Studies in Economics and Management Science

Abstract: The purpose of this paper is to examine the two-fund separation paradigm in the context of an infinite-horizon general equilibrium model with dynamically complete markets and heterogeneous consumers with time and state separable utility functions. With the exception of the dynamic structure, we maintain the assumptions of the classical static models that exhibit two-fund separation with a riskless security. In addition to a se- curity with state-independent payoffs agents can trade a collection of assets with dividends following a time-homogeneous Markov process. We make no further assumptions about the distribution of asset dividends, returns, or prices. Agents have equi-cautious HARA utility functions. If the riskless security in the economy is a consol then agents' portfolios exhibit two-fund separation. But if agents can trade only a one-period bond, this result no longer holds. Examples show this effect to be quantitatively signifcant. The underly- ing intuition is that general equilibrium restrictions lead to interest rate °uctuations that destroy the optimality of two-fund separation in economies with a one-period bond and result in different equilibrium portfolios.

Date: 2005-01
New Economics Papers: this item is included in nep-dge and nep-upt
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Related works:
Journal Article: Two-fund separation in dynamic general equilibrium (2007)
Working Paper: Two-Fund Separation in Dynamic General Equilibrium (2005)
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