IDEAS home Printed from https://ideas.repec.org/p/roc/rocher/478.html
   My bibliography  Save this paper

A Two-Person Dynamic Equilibrium under Ambiguity

Author

Listed:

Abstract

This paper describes a pure-exchange, continuous-time economy with two heterogeneous agents and complete markets. A novel feature of the economy is that agents perceive some security returns as ambiguous in the sense often attributed to frank Knight. The equilibrium is described completely in closed-form. In particular, closed-form solutions are obtained for the equilibrium processes describing individual consumption, the interest rate, the market price of uncertainty, security prices and trading strategies. After identifying agents as countries, the model is applied to address the consumption home-bias puzzles.

Suggested Citation

  • Larry G. Epstein & JianJun Miao, 2001. "A Two-Person Dynamic Equilibrium under Ambiguity," RCER Working Papers 478, University of Rochester - Center for Economic Research (RCER).
    • Handle: RePEc:roc:rocher:478
    as

    Download full text from publisher

    File URL: http://rcer.econ.rochester.edu/RCERPAPERS/rcer_478.pdf
    File Function: full text
    Download Restriction: None
    ---><---

    Other versions of this item:

    References listed on IDEAS

    as
    1. Basak, Suleyman & Cuoco, Domenico, 1998. "An Equilibrium Model with Restricted Stock Market Participation," The Review of Financial Studies, Society for Financial Studies, vol. 11(2), pages 309-341.
    2. Karen K. Lewis, 1999. "Trying to Explain Home Bias in Equities and Consumption," Journal of Economic Literature, American Economic Association, vol. 37(2), pages 571-608, June.
    3. Philip H. Dybvig, Chi-fu Huang, 1988. "Nonnegative Wealth, Absence of Arbitrage, and Feasible Consumption Plans," The Review of Financial Studies, Society for Financial Studies, vol. 1(4), pages 377-401.
    4. Zengjing Chen & Larry Epstein, 2002. "Ambiguity, Risk, and Asset Returns in Continuous Time," Econometrica, Econometric Society, vol. 70(4), pages 1403-1443, July.
    5. Shiller, Robert J & Kon-Ya, Fumiko & Tsutsui, Yoshiro, 1996. "Why Did the Nikkei Crash? Expanding the Scope of Expectations Data Collection," The Review of Economics and Statistics, MIT Press, vol. 78(1), pages 156-164, February.
    6. Dumas, Bernard & Uppal, Raman & Wang, Tan, 2000. "Efficient Intertemporal Allocations with Recursive Utility," Journal of Economic Theory, Elsevier, vol. 93(2), pages 240-259, August.
    7. Brennan, Michael J & Cao, H Henry, 1997. "International Portfolio Investment Flows," Journal of Finance, American Finance Association, vol. 52(5), pages 1851-1880, December.
    8. N. El Karoui & S. Peng & M. C. Quenez, 1997. "Backward Stochastic Differential Equations in Finance," Mathematical Finance, Wiley Blackwell, vol. 7(1), pages 1-71, January.
    9. Campbell, John Y., 1999. "Asset prices, consumption, and the business cycle," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 19, pages 1231-1303, Elsevier.
    10. Duffie, Darrel & Lions, Pierre-Louis, 1992. "PDE solutions of stochastic differential utility," Journal of Mathematical Economics, Elsevier, vol. 21(6), pages 577-606.
    11. Detemple Jerome & Murthy Shashidhar, 1994. "Intertemporal Asset Pricing with Heterogeneous Beliefs," Journal of Economic Theory, Elsevier, vol. 62(2), pages 294-320, April.
    12. Epstein, Larry G. & Schneider, Martin, 2003. "Recursive multiple-priors," Journal of Economic Theory, Elsevier, vol. 113(1), pages 1-31, November.
    13. Huberman, Gur, 2001. "Familiarity Breeds Investment," The Review of Financial Studies, Society for Financial Studies, vol. 14(3), pages 659-680.
    14. Lars Peter Hansen & Thomas J Sargent, 2014. "Robust Permanent Income and Pricing," World Scientific Book Chapters, in: UNCERTAINTY WITHIN ECONOMIC MODELS, chapter 3, pages 33-81, World Scientific Publishing Co. Pte. Ltd..
    15. French, Kenneth R & Poterba, James M, 1991. "Investor Diversification and International Equity Markets," American Economic Review, American Economic Association, vol. 81(2), pages 222-226, May.
    16. Basak, Suleyman, 2000. "A model of dynamic equilibrium asset pricing with heterogeneous beliefs and extraneous risk," Journal of Economic Dynamics and Control, Elsevier, vol. 24(1), pages 63-95, January.
    17. Duffie, Darrell & Epstein, Larry G, 1992. "Stochastic Differential Utility," Econometrica, Econometric Society, vol. 60(2), pages 353-394, March.
    18. Jacobs,Donald P. & Kalai,Ehud & Kamien,Morton I. & Schwartz,Nancy L. (ed.), 1998. "Frontiers of Research in Economic Theory," Cambridge Books, Cambridge University Press, number 9780521635387, January.
    19. Morris, Stephen, 1995. "The Common Prior Assumption in Economic Theory," Economics and Philosophy, Cambridge University Press, vol. 11(2), pages 227-253, October.
    20. Epstein, Larry G & Wang, Tan, 1994. "Intertemporal Asset Pricing Under Knightian Uncertainty," Econometrica, Econometric Society, vol. 62(2), pages 283-322, March.
    21. Mark Grinblatt & Matti Keloharju, 2001. "How Distance, Language, and Culture Influence Stockholdings and Trades," Journal of Finance, American Finance Association, vol. 56(3), pages 1053-1073, June.
    22. Dumas, Bernard, 1989. "Two-Person Dynamic Equilibrium in the Capital Market," The Review of Financial Studies, Society for Financial Studies, vol. 2(2), pages 157-188.
    23. Zapatero, Fernando, 1998. "Effects of financial innovations on market volatility when beliefs are heterogeneous," Journal of Economic Dynamics and Control, Elsevier, vol. 22(4), pages 597-626, April.
    24. Duffie, Darrell & Epstein, Larry G, 1992. "Asset Pricing with Stochastic Differential Utility," The Review of Financial Studies, Society for Financial Studies, vol. 5(3), pages 411-436.
    25. Jiang, Wang, 1996. "The term structure of interest rates in a pure exchange economy with heterogeneous investors," Journal of Financial Economics, Elsevier, vol. 41(1), pages 75-110, May.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Massimo Guidolin & Francesca Rinaldi, 2013. "Ambiguity in asset pricing and portfolio choice: a review of the literature," Theory and Decision, Springer, vol. 74(2), pages 183-217, February.
    2. Chabakauri, Georgy, 2010. "Asset pricing with heterogeneous investors and portfolio constraints," LSE Research Online Documents on Economics 43142, London School of Economics and Political Science, LSE Library.
    3. Raman Uppal & Tan Wang, 2003. "Model Misspecification and Underdiversification," Journal of Finance, American Finance Association, vol. 58(6), pages 2465-2486, December.
    4. Jianjun Miao, 2009. "Ambiguity, Risk and Portfolio Choice under Incomplete Information," Annals of Economics and Finance, Society for AEF, vol. 10(2), pages 257-279, November.
    5. repec:dau:papers:123456789/5374 is not listed on IDEAS
    6. Panageas, Stavros, 2020. "The Implications of Heterogeneity and Inequality for Asset Pricing," Foundations and Trends(R) in Finance, now publishers, vol. 12(3), pages 199-275, November.
    7. Shi, Zhan, 2019. "Time-varying ambiguity, credit spreads, and the levered equity premium," Journal of Financial Economics, Elsevier, vol. 134(3), pages 617-646.
    8. De Santis, Roberto A. & Ehling, Paul, 2007. "Do international portfolio investors follow firms' foreign investment decisions?," Working Paper Series 815, European Central Bank.
    9. Harjoat S. Bhamra & Raman Uppal, 2014. "Asset Prices with Heterogeneity in Preferences and Beliefs," The Review of Financial Studies, Society for Financial Studies, vol. 27(2), pages 519-580.
    10. Anderson, Evan W., 2005. "The dynamics of risk-sensitive allocations," Journal of Economic Theory, Elsevier, vol. 125(2), pages 93-150, December.
    11. Carole Bernard & Shaolin Ji & Weidong Tian, 2013. "An optimal insurance design problem under Knightian uncertainty," Decisions in Economics and Finance, Springer;Associazione per la Matematica, vol. 36(2), pages 99-124, November.
    12. Hongjun Yan, 2008. "Natural Selection in Financial Markets: Does It Work?," Management Science, INFORMS, vol. 54(11), pages 1935-1950, November.
    13. Kyoung Jin Choi & Hyeng Keun Koo & Do Young Kwak, 2004. "Optimal Stopping of Active Portfolio Management," Annals of Economics and Finance, Society for AEF, vol. 5(1), pages 93-126, May.
    14. Itamar Drechsler & Alexi Savov & Philipp Schnabl, 2018. "A Model of Monetary Policy and Risk Premia," Journal of Finance, American Finance Association, vol. 73(1), pages 317-373, February.
    15. Kargar, Mahyar, 2021. "Heterogeneous intermediary asset pricing," Journal of Financial Economics, Elsevier, vol. 141(2), pages 505-532.
    16. Berend Roorda & J. M. Schumacher & Jacob Engwerda, 2005. "Coherent Acceptability Measures In Multiperiod Models," Mathematical Finance, Wiley Blackwell, vol. 15(4), pages 589-612, October.
    17. Jeong, Daehee & Kim, Hwagyun & Park, Joon Y., 2015. "Does ambiguity matter? Estimating asset pricing models with a multiple-priors recursive utility," Journal of Financial Economics, Elsevier, vol. 115(2), pages 361-382.
    18. Roche, Hervé, 2011. "Asset prices in an exchange economy when agents have heterogeneous homothetic recursive preferences and no risk free bond is available," Journal of Economic Dynamics and Control, Elsevier, vol. 35(1), pages 80-96, January.
    19. Patrick Beissner & Qian Lin & Frank Riedel, 2020. "Dynamically consistent alpha‐maxmin expected utility," Mathematical Finance, Wiley Blackwell, vol. 30(3), pages 1073-1102, July.
    20. H. Henry Cao & Bing Han & David Hirshleifer & Harold H. Zhang, 2011. "Fear of the Unknown: Familiarity and Economic Decisions," Review of Finance, European Finance Association, vol. 15(1), pages 173-206.
    21. Dirk Becherer & Wilfried Kuissi-Kamdem & Olivier Menoukeu-Pamen, 2023. "Optimal consumption with labor income and borrowing constraints for recursive preferences," Working Papers hal-04017143, HAL.

    More about this item

    Keywords

    ambiguity; risk; continuous-time; asset returns; Knightian uncertainty; dynamic equilibrium; home bias;
    All these keywords.

    JEL classification:

    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • D9 - Microeconomics - - Micro-Based Behavioral Economics
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:roc:rocher:478. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Richard DiSalvo (email available below). General contact details of provider: .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.