Endogenous collateral: arbitrage and equilibrium without bounded short sales

Mario Pascoa, Aloisio Araujo and José Fajardo ()

No 418, FGV EPGE Economics Working Papers (Ensaios Economicos da EPGE) from EPGE Brazilian School of Economics and Finance - FGV EPGE (Brazil)

Abstract: We study the implications of the absence of arbitrage in an two period economy where default is allowed and assets are secured by collateral choosen by the borrowers. We show that non arbitrage sale prices of assets are submartingales, whereas non arbitrage purchase prices of the derivatives (secured by the pool of collaterals) are supermartingales. We use these non arbitrage conditions to establish existence of equilibrium, without imposing bounds on short sales. The nonconvexity of the budget set is overcome by considering a continuum of agents. Our results are particularly relevant for the collateralized mortgage obligations(CMO) markets.

Date: 2001-05-01
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Working Paper: Endogenous Collateral: Arbitrage and Equilibrium without Bounded Short Sales (2003)
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