Two-fund separation in dynamic general equilibrium

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,: Kellogg School of Management
Authors registered in the RePEc Author Service: Karl Schmedders

Theoretical Economics, 2007, vol. 2, issue 2

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)
JEL-codes: D53 G11 G12 (search for similar items in EconPapers)
Date: 2007-06-03
References: View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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Related works:
Working Paper: Two-Fund Separation in Dynamic General Equilibrium (2005)
Working Paper: Two-Fund Separation in Dynamic General Equilibrium (2005)
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Persistent link: https://EconPapers.repec.org/RePEc:the:publsh:320

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