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Equilibrium with Default and Endogenous Collateral

Aloisio Araujo, Jaime Orrillo () and Mario Pascoa

Mathematical Finance, 2000, vol. 10, issue 1, 1-21

Abstract: We study a two‐period general equilibrium model with incomplete asset markets and default. We make collateral endogenous by allowing each seller of assets to fix the level of collateral. Sellers are required to provide collateral whose first‐period value, per unit of asset, exceeds the asset price by an arbitrarily small amount. Moreover, borrowers are also required to be fully covered by the purchase, in the first period, of state‐by‐state default insurance. These insurance contracts are offered by lenders. The insurance cost or revenue is a linear charge and plays the role of a spread penalizing borrowers who will incur in default and benefiting lenders who will suffer default. Under these assumptions, equilibrium always exists.

Date: 2000
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