Equilibrium Mispricing in a Capital Market with Portfolio Constraints

Suleyman Basak and Benjamin Croitoru

Rodney L. White Center for Financial Research Working Papers from Wharton School Rodney L. White Center for Financial Research

Abstract: This paper 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.

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Journal Article: Equilibrium Mispricing in a Capital Market with Portfolio Constraints (2000)
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