Asset pricing theory is presented with representative-agent utility given by a stochastic differential formulation of recursive utility. Asset returns are characterized from general first-order conditions of the Hamilton–Bellman–Jacobi equation for optimal control. Homothetic representative-agent recursive utility functions are shown to imply that excess expected rates of return on securities are given by a linear combination of the continuous-time market-portfolio-based capital asset pricing model (CAPM) and the consumption-based CAPM. The Cox, Ingersoll, and Ross characterization of the term structure is examined with a recursive generalization, showing the response of the term structure to variations in risk aversion. Also, a new multicommodity factor-return model, as well as an extension of the “usual” discounted expected value formula for asset prices, is introduced.

This article presents a simple model of the innovation of new futures contracts by transaction volume-maximizing futures exchanges in incomplete markets under uncertainty, with mean-variance preferences and proportional transactions costs. We characterize the set of Nash equilibria for a number of exchanges simultaneously or sequentially choosing contracts. The optimal monopolistic contract design is shown to be Pareto-optimal. An example shows the failure of Pareto optimality for a particular Nash equilibrium. Likewise, in a monopolistic multiperiod setting, an example shows the failure of Pareto optimality given an incentive for the exchange to induce turnover.

A stochastic differential formulation of recursive utility is given sufficient conditions for existence, uniqueness, time consistency, monotonicity, continuity, risk aversion, concavity, and other properties. In the setting of Brownian information, recursive and intertemporal expected utility functions are observationally distinguishable. However, one cannot distinguish between a number of non-expected-utility theories of one-shot choice under uncertainty after they are suitably integrated into an intertemporal framework. In a "smooth" Markov setting, the stochastic differential utility model produces a generalization of the Hamilton-Bellman-Jacobi characterization of optimality. A companion paper explores the implications for asset prices. Copyright 1992 by The Econometric Society.

We use an extensive data set of bilateral credit default swap (CDS) positions to estimate the impact on collateral demand of new clearing and margin regulations. The estimated collateral demands include initial margin and the frictional demands associated with the movement of variation margin through the network of market participants. We estimate the impact on total collateral demand of more widespread initial margin requirements, increased novation of CDS to central clearing parties (CCPs), an increase in the number of clearing members, the proliferation of CCPs of both specialized and non-specialized types, collateral rehypothecation practices, and client clearing. System-wide collateral demand is increased significantly by the application of initial margin requirements for dealers, whether or not the CDS are cleared. Given these dealer-to-dealer initial margin requirements, mandatory central clearing is shown to lower, not raise, system-wide collateral demand, provided there is no significant proliferation of CCPs. Central clearing does, however, have significant distributional consequences for collateral requirements across market participants.

We provide maximum likelihood estimators of term structures of conditional probabilities of corporate default, incorporating the dynamics of firm-specific and macroeconomic covariates. For US Industrial firms, based on over 390,000 firm-months of data spanning 1980 to 2004, the term structure of conditional future default probabilities depends on a firm's distance to default (a volatility-adjusted measure of leverage), on the firm's trailing stock return, on trailing S&P 500 returns, and on US interest rates. The out-of-sample predictive performance of the model is an improvement over that of other available models.

We model a simple market setting in which fragmentation of trade of the same asset across multiple exchanges improves allocative efficiency. Fragmentation reduces the inhibiting effect of price-impact avoidance on order submission. Although fragmentation reduces market depth on each exchange, it also isolates cross-exchange price impacts, leading to more aggressive overall order submission and better rebalancing of unwanted positions across traders. Fragmentation also has implications for the extent to which prices reveal traders’ private information. While a given exchange price is less informative in more fragmented markets, all exchange prices taken together are more informative. (JEL D47, D82, G14)

We introduce a simple model of the “percolation ” of information of common interest through a large market, as agents encounter each other over time and reveal information to each other, some of which they may have received earlier from other agents. We are particularly interested in the evolution over time of the cross-sectional distribution in the population of the posterior probability assignments of the various agents. We provide a market example based on privately held auctions, and show how the rate of convergence of the cross-sectional distribution of information is determined by the frequency of auctions and by the number of agents bidding at each auction. Our results contribute to the literature on information transmission in markets. Hayek (1945) argues that markets allow information that is dispersed in a population to be revealed through prices. Grossman’s (1981) notion of a rational-expectations equilibrium formalizes this idea in a centralized market. A number of important markets, however, are decentralized. These include over-the-counter markets and private-auction markets. Wolinsky (1990) and Blouin and Serrano (2002) study information transmission in decentralized markets. 2 In contrast to these two papers, equilibrium behavior in our market example leads to full revelation of information

ABSTRACT The probability of extreme default losses on portfolios of U.S. corporate debt is much greater than would be estimated under the standard assumption that default correlation arises only from exposure to observable risk factors. At the high confidence levels at which bank loan portfolio and collateralized debt obligation (CDO) default losses are typically measured for economic capital and rating purposes, conventionally based loss estimates are downward biased by a full order of magnitude on test portfolios. Our estimates are based on U.S. public nonfinancial firms between 1979 and 2004. We find strong evidence for the presence of common latent factors, even when controlling for observable factors that provide the most accurate available model of firm‐by‐firm default probabilities.

In the setting of ‘affine’ jump-diffusion state processes, this paper provides an analytical treatment of a class of transforms, including various Laplace and Fourier transforms as special cases, that allow an analytical treatment of a range of valuation and econometric problems. Example applications include fixed-income pricing models, with a role for intensity-based models of default, as well as a wide range of option-pricing applications. An illustrative example examines the implications of stochastic volatility and jumps for option valuation. This example highlights the impact on option ‘smirks’ of the joint distribution of jumps in volatility and jumps in the underlying asset price, through both jump amplitude as well as jump timing.

We present a model of asset valuation in which short-selling requires searching for security lenders and bargaining over the lending fee. If lendable securities are difficult to locate, then the price of the security is initially elevated, and expected to decline. This price decline is to be anticipated, for example, after an initial public offering, and is increasing in the degree of heterogeneity of beliefs about the future value of the security. The prospect of lending fees may push the initial price of a security above even the most optimistic buyer's valuation of the security's future dividends. A higher price can thus be obtained with some shorting than if shorting is disallowed.