New applications of general equilibrium to finance: Default and collateral

Aloisio Araujo, Mário Páscoa

Research output: Chapter in Book/Report/Conference proceedingChapter

Abstract

The applications of general equilibrium to finance can be grouped into three waves. The first started with the application of the Arrow–Debreu concept of state-contingent prices developed in the fifties to a better understanding of the Black–Scholes formula and the pricing of derivatives, in general. The second wave studied the abstract incomplete markets model in its several aspects: existence, determinacy, suboptimality, and infinite horizon properties. Market incompleteness was used to understand stochastic volatility of security prices and also to explain the risk premium puzzle. We can consider as a third wave the development of general equilibrium models with default to understand credit risk and institutional arrangements that can deal with it. This third wave was made possible by the incomplete markets theory and motivated by understanding how incompleteness can be mitigated by default or bankruptcy. More specifically, this chapter addresses in its second section the finite-horizon case, covering default and penalties, collateral, and consumers' bankruptcy. The third section deals with the infinite-horizon case, where Ponzi schemes may occur. The goal of this chapter is to study credit risk in the context of general equilibrium in incomplete markets. Default and bankruptcy are important real-life phenomena: firms, consumers, exchange houses, and governments fail to honor their commitments or go bankrupt. It is therefore important to incorporate these phenomena into equilibrium models as particular configurations of equilibrium outcomes.

Original languageEnglish
Title of host publicationFrontiers in Applied General Equilibrium Modeling: In Honor of Herbert Scarf
PublisherCambridge University Press Inc
Pages151-172
Number of pages22
ISBN (Electronic)9780511614330
ISBN (Print)9780521825252
DOIs
Publication statusPublished - 1 Jan 2005

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