Two-fund separation in dynamic general equilibriumTheoretical Economics, 2007, vol. 2, issue 2, pages 135-161 Abstract: This paper examines 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. Agents have equi-cautious HARA utility functions. In addition to a security 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. If the riskless security in the economy is a consol then agents' portfolios exhibit two-fund separation. However, if agents can trade only a one-period bond, this result no longer holds. The underlying intuition is that general equilibrium restrictions lead to interest rate fluctuations that destroy the optimality of two-fund separation in economies with a one-period bond and result in different equilibrium portfolios. Keywords: Portfolio separation; dynamically complete markets; consol; one-period bond; interest rate fluctuation; reinvestment risk (search for similar items in EconPapers) Downloads: (external link) Related works: Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text Persistent link: http://EconPapers.repec.org/RePEc:the:publsh:320 Access Statistics for this article Theoretical Economics is edited by Jeffrey C. Ely, Edward Green, Barton L. Lipman, Martin J. Osborne, and Debraj Ray More articles in Theoretical Economics from Society for Economic Theory |
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