This paper considers the problem of a financial institution that needs to hedge a stream of state-contingent cash flows while facing borrowing and short-sales restrictions. The study determines analytically the strategy that minimizes the initial cost of hedging the desired cash flow, which is also the upper bound on its market price, and shows that the impact of leverage constraints on the cost of hedging call and put options is significant and, therefore, the biases detected by tests of option pricing models may not represent arbitrage opportunities. The paper also shows that with credit limits, it is optimal to reduce the rate of trading; thus, these constraints need to be recognized when estimating the trading volume generated in replicating contingent payoffs such as portfolio insurance.

With transaction costs for trading goods, the nominal exchange rate moves within a band around the nominal purchasing power parity (PPP) value. The authors model the behavior of the band and of the exchange rate within the band. The model explains why there are below-unity slope coefficients in regression tests of PPP and why these increase toward unity under hyperinflation or with low-frequency data. The authors' results are independent of the presence of nontraded goods in the economy.

In this paper, we study asset prices in a dynamic, continuous-time, and general-equilibrium endowment economy in which agents have “catching up with the Joneses” utility functions and differ with respect to their beliefs (because of differences in priors) and their preference parameters for time discount, risk aversion, and sensitivity to habit. A key contribution of our paper is to demonstrate how one can obtain a closed-form solution to the consumption-sharing rule for agents who have both heterogeneous priors and heterogeneous preferences without restricting the risk aversion of the two agents to special values. We solve in closed form also for the state-price density, the risk-free interest rate and market price of risk, the stock price, equity risk premium, and volatility of stock returns, the term structure of interest rates, and the conditions necessary to obtain a stationary equilibrium in which both agents survive in the long run. The methodology we develop is sufficiently general in that, as long as markets are complete, it can be used to obtain the sharing rule and state prices for models set in discrete or continuous time and for arbitrary endowment and belief updating processes.

We study the effect of introducing a nonredundant derivative on the volatilities of the stock market return and the locally risk-free interest rate. Our analysis uses a standard, frictionless, full-information, dynamic, continuous-time, general-equilibrium, Lucas endowment economy in which there are two classes of agents who have time-additive power utility functions and differ only in their risk aversion. Our main result is to show analytically that if the intensity of the precautionary demand for savings is not too high, then the introduction of a nonredundant derivative increases the volatility of stock market returns. Furthermore, in the economy with the derivative, the volatility of stock market returns can be substantially greater than that of aggregate dividend growth (fundamental volatility). We also show that the volatility of the locally risk-free interest rate increases with the introduction of the derivative.

We examine the effect of segmented commodity markets on the relation between forward and future spot exchange rates in a dynamic economy. We calculate the slope coefficient in our theoretical economy from regressing exchange rate changes on forward premia. With reasonable parameter values, the slope coefficient is less than unity. However, even for extreme parameters the slope is not less than zero, as found in the data. A negative slope coefficient in a nominal version of the model requires the covariance between monetary shocks and relative output shocks to be significantly negative, in contrast to the covariance in the data.

We examine the effect of segmented commodity markets on the relation between forward and future spot exchange rates in a dynamic economy. We calculate the slope coefficient in our theoretical economy from regressing exchange rate changes on forward premia. With reasonable parameter values, the slope coefficient is less than unity. However, even for extreme parameters the slope is not less than zero, as found in the data. A negative slope coefficient in a nominal version of the model requires the covariance between monetary shocks and relative output shocks to be significantly negative, in contrast to the covariance in the data.

In this paper, we examine the role that institutions may play in enabling banks to write contracts whereby sovereign debt is not forgiven ex post. Our model provides a rationale for the emergence of a centralized forum for debt renegotiation, such as the London Club, as well as for bank syndicates. These bank syndicates arise as part of a pre-commitment device rather than for risk sharing purposes. We propose a debt contract under which only involuntary default is forgiven ex post. Our main findings are that under this contract, debt forgiveness after voluntary (strategic) default is avoided. When voluntary default occurs, access to the credit market is denied only for a limited number of periods, rather than forever. In contrast to a voluntary default, involuntary default is forgiven immediately.

Chanaka Edirsinghe, Vasanttilak Naik, Raman Uppal, Optimal Replication of Options with Transactions Costs and Trading Restrictions, The Journal of Financial and Quantitative Analysis, Vol. 28, No. 1 (Mar., 1993), pp. 117-138

Households with familiarity biases tilt their portfolios toward a few risky assets. The resulting mean-variance loss from portfolio underdiversification is equivalent to only a modest reduction of about 1 percent per year in a household’s portfolio return. However, once we consider also the effect of familiarity biases on the asset- allocation and intertemporal consumption-savings decisions, the welfare loss is multiplied by a factor of four. In general equilibrium, the suboptimal decisions of households distort also aggregate growth, amplifying further the overall social welfare loss. Our findings demonstrate that financial markets are not a mere sideshow to the real economy and that improving the financial decisions of households can lead to large benefits, not just for individual households, but also for society.

To understand the dynamics of investors’ asset demands, we develop a general-equilibrium model driven by a single latent variable: heterogeneity in investors’ confidence about mean endowment growth. The model predicts persistent heterogeneity in asset demands and concentrated portfolios. Consistent with the data, limited confidence reduces investors’ demand elasticities and makes stock prices excessively volatile—driven by latent demand rather than observable characteristics. The underlying economic mechanisms are driven primarily by investors’ desire to hedge changes in future beliefs instead of current disagreement. Finally, consistent with survey data, investors’ expectations correlate positively with past returns and negatively with future returns.