Collateral, default penalties and almost finite-time solvency

V. Filipe Martins-da-Rocha and Yiannis Vailakis

No 670, FGV EPGE Economics Working Papers (Ensaios Economicos da EPGE) from EPGE Brazilian School of Economics and Finance - FGV EPGE (Brazil)

Abstract: We argue that it is possible to adapt the approach of imposing restrictions on available plans through finitely effective debt constraints, introduced by Levine and Zame (1996), to encompass models with default and collateral. Along this line, we introduce in the setting of Araujo, Páscoa and Torres-Martínez (2002) and Páscoa and Seghir (2008) the concept of almost finite-time solvency. We show that the conditions imposed in these two papers to rule out Ponzi schemes implicitly restrict actions to be almost finite-time solvent. We define the notion of equilibrium with almost finite-time solvency and look on sufficient conditions for its existence. Assuming a mild assumption on default penalties, namely that agents are myopic with respect to default penalties, we prove that existence is guaranteed (and Ponzi schemes are ruled out) when actions are restricted to be almost finite-time solvent. The proof is very simple and intuitive. In particular, the main existence results in Araujo et al. (2002) and Páscoa and Seghir (2008) are simple corollaries of our existence result.

Date: 2008-03-04
New Economics Papers: this item is included in nep-cfn
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