[We analyze complex bond portfolios within the framework of a dynamic general equilibrium asset-pricing model. Equilibrium bond portfolios are nonsensical and imply a trading volume that vastly exceeds observed trading volume on financial markets. Instead, portfolios that combine bond ladders with a market portfolio of equity assets are nearly optimal investment strategies. The welfare loss of these simple investment strategies, when compared to the equilibrium portfolio, converges to zero as the length of the bond ladder increases. This article, therefore, provides a rationale for naming bond ladders as a popular bond investment strategy.]

This paper develops theoretical foundations for an error analysis of approximate equilibria in dynamic stochastic general equilibrium models with heterogeneous agents and incomplete financial markets. While there are several algorithms that compute prices and allocations for which agents' first-order conditions are approximately satisfied (“approximate equilibria”), there are few results on how to interpret the errors in these candidate solutions and how to relate the computed allocations and prices to exact equilibrium allocations and prices. We give a simple example to illustrate that approximate equilibria might be very far from exact equilibria. We then interpret approximate equilibria as equilibria for close-by economies; that is, for economies with close-by individual endowments and preferences. We present an error analysis for two models that are commonly used in applications, an overlapping generations (OLG) model with stochastic production and an asset pricing model with infinitely lived agents. We provide sufficient conditions that ensure that approximate equilibria are close to exact equilibria of close-by economies. Numerical examples illustrate the analysis.

We consider an infinite-horizon exchange economy with incomplete markets and collateral constraints.As in the two-period model of Geanakoplos and Zame (2002), households can default on their liabilities at any time, and financial securities are only traded if the promises associated with these securities are backed by collateral.We examine an economy with a single perishable consumption good, where the only collateral available consists of productive assets.In this model, competitive equilibria always exist and we show that, under the assumption that all exogenous variables follow a Markov chain, there also exist stationary equilibria.These equilibria can be characterized by a mapping from the exogenous shock and the current distribution of financial wealth to prices and portfolio choices.We develop an algorithm to approximate this mapping numerically and discuss ways to implement the algorithm in practice.A computational example demonstrates the performance of the algorithm and shows some quantitative features of equilibria in a model with collateral and default.

We compare asset prices in an overlapping generations model for incomplete and complete markets. Individuals within a generational cohort have heterogeneous beliefs about future states of the economy and thus would like to make bets against each other. In the incomplete-markets economy, agents cannot make such bets. Asset price volatility is very small. The situation changes dramatically when markets are completed through financial innovations as the set of available securities now allows agents with different beliefs to place bets against each other. Wealth shifts across agents and generations. Such changes in the wealth distribution lead to substantial asset price volatility.

This paper shows how standard arguments supporting the imposition of price caps break down in the presence of demand uncertainty. In particular, though in the deterministic case the introduction or lowering of a price cap (above marginal cost) results in increased production, increased total welfare, decreased prices, and increased consumer welfare, we show that all of the above comparative statics predictions fail for generic uncertain demand functions. For example, for price caps sufficiently close to marginal cost, a decrease in the price cap always leads to a decrease in production and total welfare under certain mild conditions. Under stronger regularity assumptions, all of the monotone comparative statics predictions from the deterministic case also do not hold for a generic uncertain demand if we restrict attention to price caps in an arbitrary fixed interval (as long as the price caps are binding for some values in that interval).

This paper presents a new method for the analysis of moral hazard principal-agent problems. The new approach avoids the stringent assumptions on the dis-tribution of outcomes made by the classical first-order approach and instead only requires the agent’s expected utility to be a rational function of the action. This assumption allows for a reformulation of the agent’s utility maximization problem as an equivalent system of equations and inequalities. This reformulation in turn trans-forms the principal’s utility maximization problem into a nonlinear program. Under the additional assumptions that the principal’s expected utility is a polynomial and the agent’s expected utility is rational in the wage, the final nonlinear program can be solved to global optimality. The paper also shows that the polynomial optimiza-tion approach, unlike the classical approach, extends to principal-agent models with multi-dimensional action sets.

This paper shows that belief differences have strong effects on asset prices in consumption-based asset-pricing models with long-run risks. Belief heterogeneity leads to time-varying consumption and wealth shares of the agents. This time variation can resolve several asset-pricing puzzles, including the large countercyclical variation of expected risk premia, the volatility of the price-dividend ratio, the predictability of cash flows and returns, and the large predictability of returns in recessions. These findings show that belief differences, a widely observed attribute of investors, significantly improve the explanatory power of long-run risk asset-pricing models.

Modern asset pricing models combine recursive preferences with complex dynamics for the underlying consumption process. The existence of solutions is for many of these models an unsettled question. This paper introduces a novel technique to prove existence and nonexistence, as well as uniqueness for models with recursive preferences. The approach applies to many models of interest, including those with long-run consumption risks, with stochastic volatility and jumps, with time-varying consumption disasters, and with smooth ambiguity aversion and learning. Collectively, the proven results settle the existence question for many of today’s leading asset pricing models.

We analyze complex bond portfolios within the framework of a dynamic general equilibrium asset-pricing model. Equilibrium bond portfolios are nonsensical and imply a trading volume that vastly exceeds observed trading volume on financial markets. Instead, portfolios that combine bond ladders with a market portfolio of equity assets are nearly optimal investment strategies. The welfare loss of these simple investment strategies, when compared to the equilibrium portfolio, converges to zero as the length of the bond ladder increases. This article, therefore, provides a rationale for naming bond ladders as a popular bond investment strategy.

This paper shows that the latest generation of asset pricing models with long‐run risk exhibit economically significant nonlinearities, and thus the ubiquitous Campbell‐Shiller log‐linearization can generate large numerical errors. These errors translate in turn to considerable errors in the model predictions, for example, for the magnitude of the equity premium or return predictability. We demonstrate that these nonlinearities arise from the presence of multiple highly persistent processes, which cause the exogenous states to attain values far away from their long‐run means with nonnegligible probability. These extreme values have a significant impact on asset price dynamics.