Two-fund separation in dynamic general equilibrium

Karl Schmedders*

*Corresponding author for this work

Research output: Contribution to journalArticle

4 Scopus citations

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.

Original languageEnglish (US)
Pages (from-to)135-161
Number of pages27
JournalTheoretical Economics
Volume2
Issue number2
StatePublished - Jun 1 2007

Keywords

  • Consol
  • Dynamically complete markets
  • Interest rate fluctuation
  • One-period bond
  • Portfolio separation
  • Reinvestment risk

ASJC Scopus subject areas

  • Economics, Econometrics and Finance(all)

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