ECON 4051: Financial Asset Pricing

Lecture 3: Complete Financial Market Economy

The Arrow-Debreu Security Market Economy
From this lecture, we are going to use the financial market economy introduced in Lecture 2 to analyze the following three basic questions proposed
in Lecture 1:
I: Asset Pricing Problem
How are the prices of financial assets determined?
II: Portfolio Selection Problem
How do the economic agents choose their portfolio in such an economy?
III: Eciency Problem
Is the equilibrium allocation Pareto ecient?
Of course, the answers to the above three questions depend on the assumptions made on the structure of the financial economy. That is,
the answers depend on the assumptions made on the following three things:
1. the economic agents.
2. the financial assets.
3. the financial markets.
As we said in Lecture 1, basically, there are three approaches. First, we
talk about approach I. In this approach, the assumption on agents is
Assumption: All economic agents are rational.
With this assumption plus the assumptions to be stated later, the agents
have a continuous and strictly increasing and quasi-concave utility function.
For simplicity, we also assume the utility function is dierentiable, but not
assume the utility function to have particular form, for example, expected
utility.
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With this assumption, we are going to study two extreme economies: the
complete (Arrow-Debreu) security market economy and the general incomplete security market economy.
In this lecture, we focus on the complete (Arrow-Debreu) security economy.

The Arrow-Debreu Security Market Economy

Recall the model with two periods 0 and 1, states:

1
..
.

%

& ...

=0

=1

Definition 1 An Arrow-Debreu security at state is the following payo

0
..
.

1 state
.
..
0
Denote it by

That is, an Arrow-Debreu security at pays 1 unit of time 1 consumption

good if state happens and nothing at the rest of states.
Sometimes, we use 1 (indicator function) to represent the Arrow-Debreu
security at .
Note: the Arrow-Debreu security at is called state--contingent claim,
or state--contingent security. Therefore, for one state, we have one ArrowDebreu security. In total, we have Arrow-Debreu securities. The financial
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market structure is

1 0 0
.
.
..
. .. ..

= 0 1 0 =

.
.. ... ...
0 0 1

where is the identity matrix.

Let be the price of Arrow-Debreu security at . That is, is the #
of units of consumption good at time 0. also is called the state price of
since pays 1 unit of consumption good only at state .

1

2
= .. = (1 2 )>
.

is the state price vector of all the Arrow-Debreu securities.

Example 1

=0

%
&

state 1 rain tomorrow

state 2 sunshine tomorrow
=1

Thus, there will have two umbrellas contingent on the weather in tomorrow.

1
Umbrella 1 =
0

0
Umbrella 2 =

1
That is, Umbrella 1: The umbrella to be delivered in tomorrow if it will rain
tomorrow; and Umbrella 2: The umbrella to be delivered in tomorrow if it
will be sunshine tomorrow. The price for Umbrella 1 is the price of rain
tomorrow and the price for Umbrella 2 is the price of sunshine tomorrow.
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Since 1 0, we require 0. Remember there is no free lunch.

Actually, the assumption that there is no free lunch can imply much more
and we will talk about it in more detail in the next lecture.
Next, we introduce a very important concept: completeness of markets:
Definition 2 For a given financial market structure

11 21
1
1 2
1 2

2
2
2
= = ..
.. . .
..
.
.
.
.
1 2

say financial asset markets are complete if for any time 1 consumption
bundle 1 1 , there exists a portfolio = (1 2 )> such that
= 1

That is, at time 1, the portfolio will give the same payos as the consumption bundle 1 . The meaning of complete market is: you could buy any
time 1 consumption bundle from the existing markets if you have enough
time 0 consumption good.
Suppose

1
2

= .. = (1 2 )>
.

is the price vector of financial assets. How many units of time 0 consumption goods do we need to buy the portfolio supporting the consumption
bundle 1 ?
>
Question 1 Are Arrow-Debreu security markets complete?

Yes. Why? Next is the proof.

Proof. For any time 1 consumption bundle 1 = (11 12 1 )> , we
just need to buy the following portfolio = (11 12 1 )> and get the
exact payos as 1 at time 1. And its cost is > = > 1
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Example 2 (The Lucas tree economy)

%
&

state 1 good weather

state 2 bad weather

=0

=1

Suppose there is only one riskless financial asset whose payos at time 1
are 1 at both states. That is

1
0

=
1
Is market complete?
No. For example, for consumption plan at time 1

1
1 =

2
can you find a portfolio = () such that

1

?
=
=
2

No since it is impossible to have both

=1
and
= 2
Next, we move to how an economic agent makes decision in an ArrowDebreu security market economy.
Consider an economic agent with ( ):
= R1+
+ ;
can be represented by a utility function (), = R1+
+ ;
= (0 11 12 1 )> 0;
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 Financial asset structure

1 0 0
.
.
..
. .. ..

= 0 1 0

.
.. ... ...
0 0 1

The prices are = (1 2 )> 0

Since the Arrow-Debreu security markets are complete, therefore
1. The agent can buy whatever he wants on time 0s markets if
he has enough time 0 consumption goods. In other words, the
agent can buy any time 1 consumption plan if he has enough time 0
consumption goods; and
2. The agent can sell whatever he has on markets to transform it
into time 0 consumption goods. In other words, the agent can sell
his time 1 endowment on markets and get his total income represented
by time 0 consumption good.
Given Arrow-Debreu security price vector = (1 2 )> and the
agents endowment = (0 11 12 1 ).
What does the agent have?
He has the endowment
= (0 11 12 1 )
Since the markets are complete, he wants to sell all his time 1 endowments
on time 0s financial markets to transform them into time 0s wealth (good).
Time 1 endowment 1 = (11 12 1 ) is equivalent to having a portfolio
>
= >
1 = (11 12 1 )
That is,
11 # of 1
12 # of 2
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1 # of
Thus, the agent has total time 0 wealth
= 0 + > 1
What does he want to buy for time 1s consumption bundle and time 0s
consumption good?
Next, suppose he is going to buy consumption bundle
= (0 1 ) = (0 11 12 1 )
Since the markets are complete, he can buy these as long as he has enough
wealth at time 0.
Similarly, time 1 consumption plan 1 is equivalent to buying a portfolio
= (11 12 1 )>
11 # of 1
12 # of 2

1 # of
Therefore, its total cost of this consumption bundle is
0 + > 1
Thus, the agents feasible budget set is
: 0 + > 1 0 + > 1 }
( ) = { R1+
+
It is noted that there is a unique inequality for expressing the agents budget
set in A-D economy though there are two time periods and states of nature
at time 1 (Can you imagine why?).
Accordingly, the agent solves the following utility maximization problem:

max ()
(1)
( )
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which is equivalent to

max ()
+ > 1 0 + > 1
0
(0 1 ) R1+
+

(2)

For the solution to (2), we have

Theorem 1 Suppose is continuous and 0, then

1. The utility maximization problem (2) has at least one solution;
2. In addition, if is strictly quasi-concave ( is strictly convex), then
the utility maximization problem (2) has a unique solution = (0 1 ).
(Do you understand why?) Based on the above Theorem, to guarantee
(2) to have a solution, we make the following assumption:
Assumption 1 is continuous and strictly convex.
With Assumption 1, there exists a continuous and strictly quasi-concave
utility to represent
From now on, we make Assumption 1. Further, we make the following
assumption:
Assumption 2 is dierentiable and

11

..
.

With Assumptions 1 and 2, (2) is equivalent to the following

max ()
+ > 1 = 0 + > 1
0
(0 1 ) R1+
+

(Can you imagine why?)

(3)

With Assumptions 1 and 2, we can use the Kuhn-Tucker method to find

the unique solution. To solve the above problem, we first write the associated
Lagrangean
L = () [0 + > 1 0 > 1 ] 0 0 >
1 1
The first-order conditions are

()
L

0 = 0 0 = 0
()
L
=
1 = 0
1
1

= 1 2

and

0 + > 1 = 0 + > 1

(0 1 )> 0

0 0 + >
1 1 = 0

It is well-known that solving a K-T problem is very complicated since we

may have corner solutions.
Definition 3 Say that a solution is a corner solution if it is on the boundary.
To avoid having corner solutions, we make another assumption: the Inada
condition.
Assumption 3

(0 1 )70+
lim

11

..
.

11

..
.

= +

0+

That is, the agents marginal utility at point 0 is +. Therefore, to

maximize his utility, the agent has to consume something positive quantity
at all times 0 and 1 and at all states.
Theorem 2 If Assumption 3 is satisfied, then the utility maximization problem has no corner solutions.
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If there are no corner solutions, then the utility maximization problem

becomes

max ()
(*)
+ > 1 = 0 + > 1
0
1+
(0 1 ) R++

For (*) problem, we can use the Lagrangean method to find the unique
solution as follows:
The Lagrangean is
L = () [0 + > 1 0 > 1 ]

The first-order conditions are

()
L

0 = 0 = 0
()
L
=
= 0
1
1

= 1 2

plus budget constraint

0 + > 1 = 0 + > 1
Any solution to the above first-order conditions is our solution.
From the first order conditions, we have:
(1)
()
=
0
That is, is the marginal utility at time 0;
(2)
()
=
0
()
= =
1

1
=

0
1
What is 1 =? one unit of consumption good at time 0 is equivalent

to 1 units of consumption goods at time 1 and at state . Thus,

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= 1 1 tells us: The marginal utility of consuming one unit

consumption good at time 0 is equal to the utility of consuming 1

units of consumption goods at time 1 and at state .

(3)
()
= = 1 2
1
imply

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In other words, the ratio of the marginal utility at state to at state

0 equals the ratio of the state price to 0 .
Next is an example to show us how to find the solution to utility maximization problem.

Example 3 Consider an agent in an Arrow-Debreu economy with R1+2

+ ,
where is represented by utility function
(0 11 12 ) = log 0 +

1
[log 11 + log 12 ]
2

and = (0 11 12 ) 0 Find the agents optimal solution.

Solution: Do we need to consider corner solutions? No, since

1
=
+ as 0 0 +
0
0

1 1
=
+ as 1 0 +
1
2 1
= 1 2
That is, Assumption 3 is satisfied.
Thus, we can use the Lagrangean method to find the optimal solution:
L = () [0 + 1 11 + 2 12 0 1 11 2 12 ]

11

1
=
= =0
0
0
0
L

1 1
=
1 =
1 = 0
11
11
2 11
L

1 1
=
2 =
2 = 0
12
12
2 12
and
0 =

1
1
1
11 =
12 =

21
22

Let
0 + 1 11 + 2 12 = = 0 + 1 11 + 2 12
We have:

12 =

0 = 11 =
2
41
42
Thus, the example is completed.

The Arrow-Debreu Security Market Equilibrium

We begin this section with the following definition:

Definition 4 An Arrow-Debreu equilibrium is a set of state prices { }
=1

and a set of consumption bundles {(

)}
such
that:
0
1
=1

1. Given the state prices { }
=1 for each = 1 2 (0 1 ) is a
solution to the following utility maximization problem. That is,

(
0 1 ) = arg

max

0 +> 1 =0 +> 1

( ) = 1 2

2. All + 1 markets clear. That is,

=1

=1

=
0

1 =

for = 1 2

=1

P
=1

0 (spot market)
1 (financial market)

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We are interested in three questions about Arrow-Debreu equilibrium:

Question 2 Does there exist AD equilibrium?
Question 3 How are the equilibrium prices of Arrow-Debreu securities determined?
Question 4 Is Arrow-Debreu security market ecient?
Next, we will answer them one by one.
Theorem 3 If Assumptions 1-2 are satisfied, then Arrow-Debreu security
market equilibrium exists.
From the equilibrium conditions and the first-order conditions, we have:
For any agents 0
0
0

( )
1

( )
0

= =

0 (0 )

where 0 = 1 2 This leads to the following

Theorem 4 If Assumptions 1-3 are satisfied, then the Arrow-Debreu security 0 s price is determined by
( )
1
( )
0

= = 1 2

for any = 1 2
This theorem tells us that the state price is the ratio of the marginal
utility at time 1 and at state to the marginal utility at time 0.
From
( )
1
( )
0

we get

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1. Given any agent 0 s equilibrium consumption bundle (
0 1 ) we can
find the equilibrium price for any Arrow-Debreu security
( )

1
( )
0

2. Given the equilibrium Arrow-Debreu security price { }

=1 we can
0

find any agent s equilibrium consumption bundle (0 1 ) from
( )
1
( )
0

Next is an example to show us how to find the equilibrium state prices:

Example 4 Consider an Arrow-Debreu economy: = 0 and 1 and two states
of nature at time 1: 1 and 2 with the same probability 1/2. There are two
agents in the economy:

1+2 1 1
2 2

R+ and R1+2
+

where 1 = 2 are represented by utility function

(0 11 12 ) = log 0 +

1
(log 11 + log 12 )
2

and
1 = (100 0 0) and 2 = (0 200 50)
Find equilibrium prices 1 and 2 of 1 and 2
Solution: Given (1 2 )> 0 both agents solve utility maximization
problems. According to the example talked before
0 =

12 =
= 1 2
11 =
2
41
42

where
1 = > 1 = 100 2 = > 2 = 2001 + 502
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In equilibrium, all the three markets clear.

100 2001 + 502
+
= 100
2
2
100 2001 + 502
=
+
= 200
41
41

10 + 20 = 10 + 20 =
111 + 211 = 111 + 211
That is,

41 + 2 = 2
121 2 = 2
Finally,

1
4
= 2 = 2 41 = 1
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4
Next, we ask how Arrow-Debreu security markets help the agents for the
resource reallocation. For the eciency, we have
1 =

Theorem 5 The equilibrium allocation in Arrow-Debreu security market

economy is Pareto ecient.
In other words, an Arrow-Debreu security market economy is ecient.
Do you know why? (AD security marks are complete!)
Finally, we ask a very interesting question:
Question 5 At time 1, one state of nature would be revealed, and there
would be no more uncertainty. Now, suppose spot market would open again
at time 1. The question is: Are the agents going to trade each other again?
Is there any incentive to make them to trade again?
No. Why not?
Before spot market open at time 1, all the agents go to Arrow-Debreu
security markets. First, they exchange their time 1 endowments for time 0
consumption goods; Then they use the time 0 consumption goods to buy
their optimal portfolio 1 After exchanging in the Arrow-Debreu security
markets, each agent gets his or her equilibrium allocation. From the above
Theorem, the equilibrium allocation in Arrow-Debreu security market economy is Pareto ecient.
If they would trade again at time 1, it means that time 0s equilibrium
allocation would be dominated by the new allocation. However, the new
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consumption bundle could be derived at time 0 by using Arrow-Debreu security markets, therefore, the original Arrow-Debreu equilibrium allocation
should be not Pareto ecient. But this leads to a contradiction.
Summary: An Arrow-Debreu security market economy has the
following properties:
1. Arrow-Debreu security markets are complete;
2. The AD security 0 s price is
( )

1
( )
0

for any = 1 2 and = 1 2

3. An Arrow-Debreu security market economy is ecient.
4. At time 0, both spot market for time 0 consumption good and financial
markets for Arrow-Debreu securities are open. But there are no more
any spot markets open at time 1. In other words, all the trading takes
place only at time 0.
From the above properties, we can see that the Arrow-Debreu security
market economy is an ideal economy. This leads us to ask:
Question 6 Why do we have the above wonderful results in the ArrowDebreu security market economy?
Because the Arrow-Debreu security markets are complete, at time 0, you
can exchange between time 0 and time 1, between any two states of nature
through Arrow-Debreu security markets. That is, at time 0, you can use
Arrow-Debreu security markets to make a consumption plan for your whole
life and never change it. What you need to do at each period in the future
is just to follow the plan.
The Arrow-Debreu security market economy is too good (to be true!). It
leads us to ask the next question:
Question 7 Is the Arrow-Debreu security market economy true? In other
words, is there the Arrow-Debreu security market economy in reality? From
where, can we buy the Arrow-Debreu securities?
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Unfortunately, no where we can buy them. Actually, there are no such

securities. The question is why?
Can you imagine how many states of nature we have in reality in general? Infinite! Can we open an infinite number of markets? No, too much
transaction cost.
More importantly, some markets will be missing due to the opportunistic
behavior of human being (adverse selection and moral hazard.)
What do we have in reality? At each time, there are spot markets on
which the agents can buy or sell consumption goods and financial markets on
which the agent will buy or sell financial assets for redistribute the income
between the future and the present or between two dierent states in the
future.
Though the equilibrium prices have the following expression
( )

1
( )
0

for any = 1 2 and = 1 2 they are not very useful since they
depend on the equilibrium allocation { } which is not observable. What
we can observe in reality is a countrys GDP! It would be wonderful if the
equilibrium prices depend on the total endowment
P
= =1 =

We will be back to this problem later.

From the next lecture, we will study some real financed assets and their
markets. But, please remember, the Arrow-Debreu security market economy
is a benchmark and we will compare the real market economy with it often
and to see how well the real financial market economy works for resource
allocation.
Next is the part I of Assignment 1. I will give you the whole
assignment 1 and specify the due day later.
Part I of Assignment 1
1. (20 marks) Consider an economy with two periods and two states of
the world at time 1 and one perishable consumption good. Consider
one agent in this economy with endowment (0 2 1) and utility function
(0 11 12 ) = ln 0 + ln 11 + ln 12
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(a) Write the Arrow-Debreu security market structure .

(b) Find a portfolio supporting the agents endowment.
(c) Let the prices of the two AD securities be = (1 2 ) 0 Find
the agents total financial wealth at time 0 and find his feasible
budget set.
(d) Verify the Inada condition and find the agents optimal consumption bundle .
2. (20 marks) Consider an economy with two periods and ONE state of
the world at time 1 (i.e. there is no uncertainty in this economy) and
one perishable good. Suppose there is only one agent in this economy
with endowment (100 1) and utility function
(0 1 ) = ln 0 + ln 1
where 0 1 is the agents time discount factor. Suppose there is
only one riskless asset with payo 1 + at time 1 and and price 1 at
time 0, where is the interest rate.
(a) Find the agents total financial wealth at time 0 and find his feasible budget set.
(b) Given interest rate find the agents optimal portfolio
(c) Find the equilibrium interest rate
(d) Find the relationship between time discount factor and equilibrium interest rate Interpret what you have derived.
3. (20 marks) Suppose that the economy is the same as in question 2
except that there is another agent with endowment (1 100) and the
same utility function as the one in question 2.
(a) Given interest rate find the second agents optimal portfolio
(b) Find the equilibrium interest rate

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