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Title:Two-fund separation in dynamic general equilibrium PDF Logo
Authors:Schmedders, Karl
Issue Date:2004
Series/Report no.:Discussion paper // Center for Mathematical Studies in Economics and Management Science 1398
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-homogeneousMarkov 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.
Subjects:Portfolio separation
dynamically complete markets
consol
oneperiod bond
interest rate fluctuation
reinvestment risk
JEL:D53
G11
G12
Document Type:Working Paper
Appears in Collections:Discussion Papers, Kellogg School of Management, Northwestern University

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