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Endogenous Leverage in a Binomial Economy: The Irrelevance of Actual Default

Ana Fostel and John Geanakoplos ()
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John Geanakoplos: Cowles Foundation, Yale University, http://economics.yale.edu/people/john-geanakoplos

No 1877, Cowles Foundation Discussion Papers from Cowles Foundation for Research in Economics, Yale University

Abstract: We show that binomial economies with financial assets are an informative and tractable model to study endogenous leverage and collateral equilibrium: endogenous leverage can be highly volatile, but it is always easy to compute. The possibility of default can have a dramatic effect on equilibrium, if collateral is scarce, yet we prove the No-Default Theorem asserting that, without loss of generality, there is no default in equilibrium. Thus potential default has a dramatic effect on equilibrium, but actual default does not. This result is valid with arbitrary preferences, contingent promises, many assets and consumption goods, production, and multiple periods. On the other hand, we show that the theorem fails in trinomial models. For example, in a CAPM model, we find that default is robust. In a model with heterogeneous beliefs, we find that different agents might borrow on the same asset with different LTVs.

Keywords: Endogenous leverage; Collateral equilibrium; Default; Financial asset; Binomial economy; VaR (search for similar items in EconPapers)
JEL-codes: D52 D53 E44 G01 G11 G12 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-fdg
Date: 2012-09
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