Equilibrium Mispricing in a Capital Market with Portfolio Constraints

Suleyman Basak and Benjamin Croitoru

The Review of Financial Studies, 2000, vol. 13, issue 3, 715-48

Abstract: This article develops a general equilibrium, continuous time model where portfolio constraints generate mispricing between redundant securities. Constrained consumption-portfolio optimization techniques are adapted to incorporate redundant, possibly mispriced securities. Under logarithmic preferences, we provide explicit conditions for mispricing and closed-form expressions for all economic quantities. Existence of an equilibrium where mispricing occurs with positive probability is verified in a specific case. In a more general setting, we demonstrate the necessity of mispricing for equilibrium when agents are heterogeneous enough. The construction of a representative agent with stochastic weights allows us to characterize prices and allocations, given mispricing occurs. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

Date: 2000
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