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Lecture Notes
Sérgio O. Parreiras
Fall, 2014
Announcements
Thursday, August 21st, 2014
▶ PS 01 posted (yesterday!)
▶ PPE reading groups
Dear All, If you have students who might be interested, I would
appreciate you letting them know about the Reading Groups being
offered this Fall by the Philosophy, Politics, and Economics Program.
We are offering three:
1. Ridley’s The Rational Optimist
2. Feminist Arguments For and Against the Market
3. Justice: Rawls and Nozick
The groups will meet over dinner (at Gourmet Kingdom in Carrboro).
The readings will be provided and the cost of dinner will be covered.
Students can find details at http://ppe.unc.edu/reading-groups/.
Thanks for your help in getting the word out, Geoff
Announcements
Thursday, August 21st, 2014
▶ PS 01 posted (yesterday!)
▶ PPE reading groups
Dear All, If you have students who might be interested, I would
appreciate you letting them know about the Reading Groups being
offered this Fall by the Philosophy, Politics, and Economics Program.
We are offering three:
1. Ridley’s The Rational Optimist
2. Feminist Arguments For and Against the Market
3. Justice: Rawls and Nozick
The groups will meet over dinner (at Gourmet Kingdom in Carrboro).
The readings will be provided and the cost of dinner will be covered.
Students can find details at http://ppe.unc.edu/reading-groups/.
Thanks for your help in getting the word out, Geoff
Decision Theory: Lotteries
x1 x2 ... xn
p2
p1 pn
ℓ
The Certain Lottery, Expectation and Variance
δx = ((x), (1)) .
Var[ℓ1 ] =p1 · (x1 − E[ℓ1 ])2 + p2 · (x2 − E[ℓ1 ])2 + . . . pn · (xn − E[ℓ1 ])2 =
∑
n
= pi · (xi − E[ℓ1 ])2 .
i=1
Composition of Lotteries
Given two lotteries, ℓ1 = ((x1 , x2 , . . . , xn ), (p1 , p2 , . . . , pn )) and
ℓ2 = (y1 , y2 , . . . , ym ), (q1 , q2 , . . . , qn )) and a number 0 < α < 1,
one can create a compound lottery by choosing ℓ1 with
probability α and ℓ2 with probability ℓ2 .
ℓ = αℓ1 ⊕ (1 − α)ℓ2 =
= ((x1 , x2 , y1 , y2 ), (αp, α(1 − p), (1 − α)q, (1 − α)(1 − q)).
x1
x2
ℓ
y1
y2
Composition of Lotteries
x1
p
ℓ1
α x2
1−p
ℓ
1−α q
ℓ2 y1
1−q y2
Composition of Lotteries
x1
α·
p
p) x2
α · (1 −
ℓ (1 − α)
·q
(1 − y1
α)
· (1
−q
)
y2
Preferences Over Lotteries
if and only if
∑
n ∑
m
u(xk ) · pk > u(yk ) · qk .
k=1 k=1
Expected Utility
We write:
U (ℓ1 ) = u(x1 ) · p1 + . . . + u(xn ) · pn
We write:
We write:
The agent will choose the lottery that delivers the highest
expected utility.
Sometimes, it might be convenient to have the lottery
The agent will choose the lottery that delivers the highest
expected utility.
Sometimes, it might be convenient to have the lottery
The agent will choose the lottery that delivers the highest
expected utility.
Sometimes, it might be convenient to have the lottery
The agent will choose the lottery that delivers the highest
expected utility.
Sometimes, it might be convenient to have the lottery
The agent will choose the lottery that delivers the highest
expected utility.
Sometimes, it might be convenient to have the lottery
The agent will choose the lottery that delivers the highest
expected utility.
Sometimes, it might be convenient to have the lottery
√
Lottery A, initial wealth ω = 0 and u(x) = x.
√
$1000 1000
1
2 √ √
t=0 1000 0
2 + 2
1
2
√
$0 0
Decision/Probability Tree
√
Lottery B, initial wealth ω = 0 and u(x) = x
√
$500 500
1
2
√
t=0 500
1
2
√
$500 500
Decision/Probability Tree
√
$1000 + 8 1008
1
2 √ √
t=0 1008 8
2 + 2
1
2
√
$0 + 8 8
Decision/Probability Tree
√
$508 508
1
2
√
t=0 508
1
2
√
$508 508
Decision/Probability Tree
Two coins example, u(x) = − exp(x).
E[U (X )] =
8 − 1 + 10
1
2
− exp(−17)
4 +
t=1 8−1+5
1
− exp(−12)
1 2
2 4 +
≻
Extracting u from ⪰
≻
Extracting u from ⪰
≺
A Behavioral Look at Choice
▶ Anchoring
▶ Availability
▶ Representativeness
▶ Optimism and over confidence
▶ Gains and losses
▶ Status Quo Bias
▶ Framming
Risk Aversion
We have
1 1
U (ℓ1 ) = u(150 − 50) · + u(150 + 50) · and
2 2
U (δ150 ) = u(150) · 1.
Risk Aversion
We have
1 1
U (ℓ1 ) = u(150 − 50) · + u(150 + 50) · and
2 2
U (δ150 ) = u(150) · 1.
Risk Aversion
We have
1 1
U (ℓ1 ) = u(150 − 50) · + u(150 + 50) · and
2 2
U (δ150 ) = u(150) · 1.
Risk Aversion
We have
1 1
U (ℓ1 ) = u(150 − 50) · + u(150 + 50) · and
2 2
U (δ150 ) = u(150) · 1.
Risk Aversion
[ ]
u(200) − u(150) u(150) − u(100) 50
U (ℓ1 ) − U (δ150 ) = − ·
50 50 2
u(200)
u(100)
x
100 150 200
E[ℓ1 ]
Risk Aversion
u(200) − u(150) u(150) − u(100) 50
U (ℓ1 ) − U (δ150 ) =
− ·
2
| 50
{z } | 50
{z }
≃ Mu(150) ≃ Mu(100)
u(200)
U (ℓ1 )
u(100)
x
100 150 200
E[ℓ1 ]
Risk Aversion
u(200) − u(150) u(150) − u(100) 50
U (ℓ1 ) − U (δ150 ) =
− ·
2
| 50
{z } | 50
{z }
≃ Mu(150) ≃ Mu(100)
u(200)
U (ℓ1 )
u(100)
x
100 150 200
E[ℓ1 ]
Risk Aversion
u(200) − u(150) u(150) − u(100) 50
U (ℓ1 ) − U (δ150 ) =
− ·
2
| 50
{z } | 50
{z }
≃ Mu(150) ≃ Mu(100)
u(200)
U (ℓ1 )
u(100)
x
100 150 200
E[ℓ1 ]
Risk Aversion
u(200) − u(150) u(150) − u(100) 50
U (ℓ1 ) − U (δ150 ) =
− ·
2
| 50
{z } | 50
{z }
≃ Mu(150) ≃ Mu(100)
u(200)
U (ℓ1 )
u(100)
x
100 150 200
E[ℓ1 ]
Expected Utility Theory
Attitudes Towards Risk
Definition
The Arrow-Pratt absolute measure of risk-aversion of an agent
with VN-M utility u at wealth level w is:
−u ′′ (w)
ρu (w) = .
u ′ (w)
Definition
The Arrow-Pratt absolute measure of risk-aversion of an agent
with VN-M utility u at wealth level w is:
−u ′′ (w)
ρu (w) = .
u ′ (w)
Definition
The relative absolute measure of risk-aversion of an agent with
VN-M utility u at wealth level w is:
−u ′′ (w) w
ru (w) = .
u ′ (w)
Mathematics Review
Taylor’s Approximation
f (x + h) − f (x) ≃ f ′ (x) · h
f (x + h) − f (x) ≃ f ′ (x) · h
f (x + h) − f (x) ≃ f ′ (x) · h
MUx · ∆x + MUy · ∆y
Mathematical Review
Interior Solutions
Definition: f is concave if and only if, for all α ∈ [0, 1], and
any two points x, y ∈ Rk , we have
f (α x + (1 − α) y) ≥ α f (x) + (1 − α) f (y).
f (x, g(x)) = c
Key concepts:
1. Present Value
2. Arbitrage
3. Intertemporal Marginal Rate of Substitution - MRIS
Learning Goals:
1. Be able to compute PV .
2. Solve for the optimal consumption bundle.
3. Be able to justify the PV by arbitrage arguments.
Intertemporal Consumption
Key concepts:
1. Present Value
2. Arbitrage
3. Intertemporal Marginal Rate of Substitution - MRIS
Learning Goals:
1. Be able to compute PV .
2. Solve for the optimal consumption bundle.
3. Be able to justify the PV by arbitrage arguments.
Intertemporal Consumption
Key concepts:
1. Present Value
2. Arbitrage
3. Intertemporal Marginal Rate of Substitution - MRIS
Learning Goals:
1. Be able to compute PV .
2. Solve for the optimal consumption bundle.
3. Be able to justify the PV by arbitrage arguments.
Intertemporal Consumption
Key concepts:
1. Present Value
2. Arbitrage
3. Intertemporal Marginal Rate of Substitution - MRIS
Learning Goals:
1. Be able to compute PV .
2. Solve for the optimal consumption bundle.
3. Be able to justify the PV by arbitrage arguments.
Intertemporal Consumption
Key concepts:
1. Present Value
2. Arbitrage
3. Intertemporal Marginal Rate of Substitution - MRIS
Learning Goals:
1. Be able to compute PV .
2. Solve for the optimal consumption bundle.
3. Be able to justify the PV by arbitrage arguments.
Intertemporal Consumption
Key concepts:
1. Present Value
2. Arbitrage
3. Intertemporal Marginal Rate of Substitution - MRIS
Learning Goals:
1. Be able to compute PV .
2. Solve for the optimal consumption bundle.
3. Be able to justify the PV by arbitrage arguments.
Intertemporal Consumption
Key concepts:
1. Present Value
2. Arbitrage
3. Intertemporal Marginal Rate of Substitution - MRIS
Learning Goals:
1. Be able to compute PV .
2. Solve for the optimal consumption bundle.
3. Be able to justify the PV by arbitrage arguments.
Intertemporal Model (no uncertainty)
▶ t = 0, 1, . . . , T periods.
▶ one good at each period, ct consumption at period t
▶ πt = 1 is the spot price for all t (pay at the "spot")
▶ pt is the forward price (contingent price) (pay today)
t=0
p0 = π0
p1
t=1 t=2 t t=T
p2 π1 π2 πt πT
..
.
pT
Definition: A forward contract is a non-standardized contract
between two parties to buy or to sell an asset at a specified
future time at a price agreed upon today.
Intertemporal Model (no uncertainty)
▶ t = 0, 1, . . . , T periods.
▶ one good at each period, ct consumption at period t
▶ πt = 1 is the spot price for all t (pay at the "spot")
▶ pt is the forward price (contingent price) (pay today)
t=0
p0 = π0
p1
t=1 t=2 t t=T
p2 π1 π2 πt πT
..
.
pT
Definition: A forward contract is a non-standardized contract
between two parties to buy or to sell an asset at a specified
future time at a price agreed upon today.
Intertemporal Model (no uncertainty)
▶ t = 0, 1, . . . , T periods.
▶ one good at each period, ct consumption at period t
▶ πt = 1 is the spot price for all t (pay at the "spot")
▶ pt is the forward price (contingent price) (pay today)
t=0
p0 = π0
p1
t=1 t=2 t t=T
p2 π1 π2 πt πT
..
.
pT
Definition: A forward contract is a non-standardized contract
between two parties to buy or to sell an asset at a specified
future time at a price agreed upon today.
Intertemporal Model (no uncertainty)
▶ t = 0, 1, . . . , T periods.
▶ one good at each period, ct consumption at period t
▶ πt = 1 is the spot price for all t (pay at the "spot")
▶ pt is the forward price (contingent price) (pay today)
t=0
p0 = π0
p1
t=1 t=2 t t=T
p2 π1 π2 πt πT
..
.
pT
Definition: A forward contract is a non-standardized contract
between two parties to buy or to sell an asset at a specified
future time at a price agreed upon today.
Intertemporal Model (no uncertainty)
▶ t = 0, 1, . . . , T periods.
▶ one good at each period, ct consumption at period t
▶ πt = 1 is the spot price for all t (pay at the "spot")
▶ pt is the forward price (contingent price) (pay today)
t=0
p0 = π0
p1
t=1 t=2 t t=T
p2 π1 π2 πt πT
..
.
pT
Definition: A forward contract is a non-standardized contract
between two parties to buy or to sell an asset at a specified
future time at a price agreed upon today.
Intertemporal Model (no uncertainty)
▶ t = 0, 1, . . . , T periods.
▶ one good at each period, ct consumption at period t
▶ πt = 1 is the spot price for all t (pay at the "spot")
▶ pt is the forward price (contingent price) (pay today)
t=0
p0 = π0
p1
t=1 t=2 t t=T
p2 π1 π2 πt πT
..
.
pT
Definition: A forward contract is a non-standardized contract
between two parties to buy or to sell an asset at a specified
future time at a price agreed upon today.
Intertemporal Model (no uncertainty)
▶
OTC = over the counter
t = 0, 1, . . . , T periods.
▶ one good at each period, ct consumption at period t
▶ πt = 1 is the spot price for all t (pay at the "spot")
▶ pt is the forward price (contingent price) (pay today)
t=0
p0 = π0
p1
t=1 t=2 t t=T
p2 π1 π2 πt πT
..
.
pT
Definition: A forward contract is a non-standardized contract
between two parties to buy or to sell an asset at a specified
future time at a price agreed upon today.
The Relationship between Forward and Spot Prices
πt
pt = .
(1 + ı)t
▶ It cash-flow in period t
▶ ı interest rate period t to t + 1 (constant)
▶ It cash-flow in period t
▶ ı interest rate period t to t + 1 (constant)
(1 + ı)Y0 + Y1
Y1
c0
Y0 Y1
0 Y0 +
1+ı
Inter-temporal Consumption
2-Period (T = 2) Consumer Problem
max U (c0 , c1 )
c1 c1 , c2
subject to
c0 + 1
≤ Y0 + (1+ı)
(1+ı) c1
1
Y1
(1 + bı)Y0 + Y1 c0 ≥ 0 and c1 ≥ 0
(1 + ı)Y0 + Y1 ı ↗ bı
Y1
c0
Y0 Y1
0 Y1 Y0 +
Y0 + 1+ı
1 + bı
Inter-temporal Consumption
2-Period (T = 2) Consumer Problem
max U (c0 , c1 )
c1 c1 , c2
subject to
c0 + 1
≤ Y0 + (1+ı)
(1+ı) c1
1
Y1
c0 ≥ 0 and c1 ≥ 0
(1 + ı)Y0 + Y1 ı ↘ eı
Y1
(1 + eı)Y0 + Y1
c0
Y0 Y1
0 Y0 +
1+ı
Y1
Y0 +
1 + eı
The idea of arbitrage
The A’s front office realized right away, of course, that they
couldn’t replace Jason Giambi with another first baseman just
like him. There wasn’t another first baseman just like him and
if there were they couldn’t have afforded him and in any case
that’s not how they thought about the holes they had to fill.
"The important thing is not to recreate the individual," Billy
Beane would later say. "The important thing is to recreate the
aggregate." He couldn’t and wouldn’t find another Jason
Giambi; but he could find the pieces of Giambi he could least
afford to be without, and buy them for a tiny fraction of the
cost of Giambi himself. – Moneyball by Micheal Lewis, p. 103
The idea of arbitrage
continuation
The A’s front office had broken down Giambi into his obvious
offensive statistics: walks, singles, doubles, home runs along
with his less obvious ones: pitches seen per plate appearance,
walk to strikeout ratio and asked: which can we afford to
replace? And they realized that they could afford, in a
roundabout way, to replace his most critical offensive trait, his
on-base percentage, along with several less obvious ones. The
previous season Giambi’s on-base percentage had been .477, the
highest in the American League by 50 points. (Seattle’s Edgar
Martinez had been second at .423; the average American
League on-base percentage was .334.) There was no one player
who got on base half the time he came to bat that the A’s could
afford; – Moneyball by Micheal Lewis, p. 103
The idea of arbitrage
continuation
on the other hand, Jason Giambi wasn’t the only player in the
Oakland A’s lineup who needed replacing. Johnny Damon
(onbase percentage .324) was gone from center field, and the
designated hitter Olmedo Saenz (.291) was headed for the
bench. The average on-base percentage of those three players
(.364) was what Billy and Paul had set out to replace. They
went looking for three players who could play, between them,
first base, outfield, and DH, and who shared an ability to get on
base at a rate thirty points higher than the average big league
player. – Moneyball by Micheal Lewis, p. 103
Understanding Present Value
Arbitrage
MU0
MRIS ≡ =1+ı
MU1
1
c0 + c1 = PV(Y0 , Y1 )
(1 + ı)
Note: the strike price is not the price of the option (in practice,
the price of the option is called premium).
A Call Option Example
continuation
$ − 26.5 + 28 = 1.5
2
3
t=0
1
3
$0
A Call Option Example
continuation
2
3 2u(37.5−P) u(36−P)
t=0 3 + 3
1
3
36 − P
u(36 − P)
t=1
A Call Option Example
continuation
2u(37.5 − P) u(36 − P)
U (buy) = + .
3 3
1. u(x) = x =⇒ Pmax = 1.
2. u(x) = x 2 =⇒ Pmax = 1.0069. Making the DM indifferent,
√ − 74P + P = 0 so
we get 73.5 2
74− 742 −4(73.5)
P= 2 ≃ 1.0069.
√
3. u(x) = √ x =⇒ Pmax = 0.9965. Making the DM indifferent,
√
we get 2 36 − P + 32 + 36 − P = 3 · 6. The "trick" is to
√
√ y = 36 − P and remove the square root in
call
2 y 2 − 32 + y = 18 to get a quadratic equation in y. We
solve it for y and set P = 36 − y 2 .
A Call Option Example
continuation
wealth when
state H happens
Portfolio selection
continuation...
wealth when
state L happens
Portfolio selection
continuation...
U ′ (α) = 0 or equivalently,
U (c0 , c1 ) = 4 c0
Y0 Y1
0 Y0 +
1+ı
Intertemporal Choice
recap.
max u(c0 ) + δu(c1 )
c1 , c2
c1 subject to
c0 + 1
≤ Y0 + (1+ı)
(1+ı) c1
1
Y1
c0 ≥ 0 and c1 ≥ 0
U (c0 , c1 ) = 5
c0
Y0 Y1
0 Y0 +
1+ı
Intertemporal Choice
recap.
max u(c0 ) + δu(c1 )
c1 , c2
c1 subject to
c0 + 1
≤ Y0 + (1+ı)
(1+ı) c1
1
Y1
c0 ≥ 0 and c1 ≥ 0
U (c0 , c1 ) = 6
c0
Y0 Y1
0 Y0 +
1+ı
Intertemporal Choice
recap.
max u(c0 ) + δu(c1 )
c1 , c2
c1 subject to
c0 + 1
≤ Y0 + (1+ı)
(1+ı) c1
1
Y1
c0 ≥ 0 and c1 ≥ 0
U (c0 , c1 ) = 5.9
c0
Y0 Y1
0 Y0 +
1+ı
c1A General Equilibrium
0
c0B
endowment
c0A
0
c1B
c1A General Equilibrium
0
c0B
endowment
c0A
0
A’s endowment of c0
c1B
c1A General Equilibrium
0
c0B
endowment
c0A
0
B’s endowment of c0
c1B
c1A General Equilibrium
B’s endowment of c0
0
c0B
endowment
c0A
0
A’s endowment of c0
c1B
c1A General Equilibrium
B’s endowment of c0
0
c0B
B’s
en-
dow-
ment
of c1
A’s
en-
dow-
ment
endowment
of c1
c0A
0
A’s endowment of c0
c1B
c1A General Equilibrium
B’s endowment of c0
0
c0B
B’s
en-
dow-
ment
of c1
A’s
en-
dow-
ment
of c1
c0A
0
A’s endowment of c0
c1B
c1A General Equilibrium
B’s endowment of c0
0
c0B
B’s
en-
dow-
ment
of c1
A’s
en-
dow-
ment
of c1
c0A
0
A’s endowment of c0
c1B
c1A General Equilibrium
0
c0B
c0A
0
c1B
c1A General Equilibrium
0
c0B
util
ity
bet of
ter A
end tha
ow n
me
nt
c0A
0
c1B
c1A General Equilibrium
0
c0B
c0A
0
c1B
c1A General Equilibrium
0
c0B
util
ity
bet of
ter B
end tha
ow n
me
nt
c0A
0
c1B
c1A General Equilibrium
0
c0B
both
are
r
bette
off
c0A
0
c1B
c1A General Equilibrium
0
c0B
efficient
alloca-
tions
both
are
r
bette
off
SB
= MRI
MRISA
c0A
0
c1B
c1A General Equilibrium
0
c0B
efficient
alloca-
tions
SB
= MRI
MRISA
c0A
0
c1B
c1A General Equilibrium
0
c0B
efficient
alloca-
tions
SB
= MRI
MRISA
c0A
0
c1B
c1A General Equilibrium
0
c0B
efficient
alloca-
tions
SB
= MRI
MRISA
c0A
0
c1B
Uncertainty
Arrow-Debreu goods
1. Weather Markets
2. A weather contract
3. Events Markets
Complete Markets
1. Weather Markets
2. A weather contract
3. Events Markets
Complete Markets
1. Weather Markets
2. A weather contract
3. Events Markets
Complete Markets
1. Weather Markets
2. A weather contract
3. Events Markets
The Consumer Problem under Complete Markets
Two States and One Good
max
cL ,cH
πL u(cL ) + πH u(cH ).
st.
pL cL +pH cH ≤pL YL +pH YH
max
c ,c
U (cL , cH ).
L H
st.
pL cL +pH cH ≤pL YL +pH YH
and with Arrow-securities is
max
cL ,cH ,zL ,zH
U (cL , cH ).
st.
qL zL +qH zH ≤0
p̂L cL ≤p̂L YL +zL
p̂H cH ≤p̂H YH +zH
Financial Market Eq. with Arrow Securities
max
cL ,cH ,zL ,zH
U (cL , cH ).
st.
qL zL +qH zH ≤0
p̂L cL ≤p̂L YL +zL
p̂H cH ≤p̂H YH +zH
where:
▶ qs is the price of one unit of the security s.
▶ zs is the amount of securities s the consumer buys
(negative if he or she sells).
The consumer problem with expected utility (Arrow
securities)
max
cL ,cH
πL u(cL ) + πH u(cH ). (CP - Arrow securities)
st.
qL zL +qH zH ≤0
p̂L cL ≤p̂L YL +zL
p̂H cH ≤p̂H YH +zH
▶ Dates: = t = 0, 1, 2.
▶ Consumer with utility u(c) = log(c).
▶ Safe (short asset): investment of x yields x at next date.
▶ Risky (long asset): invest. x at t = 0 yields 4 x at t = 2.
▶ Long asset is illiquid at t = 1.
▶ Initial wealth: W0 = 10.
▶ Investment at t = 0, 1.
▶ Consumption at t = 1, 2 but not both.
▶ 1
With prob. 2 consumption takes place only at date 1.
▶ The fraction of wealth in short asset is β.
1 1
max log (β 10) + log (β 10 + (1 − β)40)
β 2 2
st.
0≤β≤1
Liquidity Shocks
An Example
1 1
max log (β 10) + log (β 10 + (1 − β)40)
β 2 2
st.
0≤β≤1
10 10 − 40
+ =0 (FOC)
2 (β 10) 2 (β 10 + (1 − β)40)
2
β=
3
Liquidity
with risk-pooling
▶ Two agents, i = 1, 2.
▶ Initial individual wealth, W0i = ω.
▶ Short asset with rate of return r, 1 ≤ r < R.
▶ Long asset with rate of return R.
▶ β fraction of wealth invest in short-asset.
▶ π prob. of liquidity shock (independent across agents).
▶ d amount of short-asset promised to an agent who had a
liquidity shock if the other agent did not suffer a liquidity
shock.
Liquidity
with risk-pooling (continuation)
If agents do not pool their resources, each agent choose its own
β to maximize:
( )
max πu (r β ω) + (1 − π)u r 2 β ω + (1 − β)R ω
β
st.
0≤β≤1
(INDIVIDUAL)
Without pooling:
State Probability Agent 1’s consumption
All suffer the shock π2 rβω
Only 1 suffers π(1 − π) rβω
Only 2 suffers (1 − π)π r 2 β ω + R (1 − β) ω
None suffers (1 − π)2 r 2 β ω + R (1 − β) ω
With pooling:
State Probability Agent 1’s consumption
All suffer the shock π2 βω
Only 1 suffers π(1 − π) d
Only 2 suffers (1 − π)π r (r β 2 ω − d) + R (1 − β)2 ω
None suffers (1 − π)2 r 2 β ω + R (1 − β)ω
Liquidity
with risk-pooling (continuation)
Remark 1: The agents are always better-off by pooling their
resources. The optimal (β ∗ , d ∗ ) that solves the maximization
problem (POOL) always delivers a higher utility than the β ∗∗ that
solves the maximization problem (INDIVIDUAL).
where [x] is the floor function, it gives the largest integer below x.
Law of Large Numbers
eliminating uncertainty thru averages, side comment
The model is similar the the ones we saw before. But now there
is uncertainty regarding the fraction of the population who
suffers a liquidity shock: it could be high or low, λH (in state H
that happens with prob. π) or λL (in state L that happens with
prob. 1 − π) .
▶ Dates: t = 0, 1, 2. States: s = H , L.
▶ At date 0: consumers make deposit decisions and banks
offer deposit contracts and then make portfolio decisions
(how much to invest in the short-asset and how much to
invest in the long-asset).
▶ At the start of date 1: all learn what is the current state
and mkts. open for trade.
▶ At t = 1 there are two markets: the good market (where c2
is exchanged for c1 ) and the asset market (where the
Asset Markets and Liquidity
Model Set-Up (cont.)
Ps = R · p s
▶
ps ≤ 1
Asset Markets and Liquidity Simplified Model
NOT COVERED Chapter 4- No Banks,
Let’s assume for now that consumers do their own investment: y in the
short-asset and x in the long asset, x + y = 1.
π · λH · u(c1H ) + π · (1 − λH ) · u(c2H )+
(1 − π) · λL · u(c1L ) + (1 − π) · (1 − λL ) · u(c2L )
Asset Markets and Liquidity Simplified Model
NOT COVERED Chapter 4- No Banks
Behavior in the asset market
In the good market we took as given the price of the assets P = (PH , PL ).
In the asset market, we take as given the consumption decisions and solve
for the asset prices that equate supply and demand.
▶ Ss (Ps ) = (1 − y)λs , supply of long-asset (inelastic, early consumers
sell).
(1 − λs )y
if Ps < R
Ps
▶ Ds (Ps ) = [0, (1 − λs )y if Ps = R , demand of long-asset (late
R
0 if P > R
s
consumers buy as long as price is not too high, Ps ≤ R)
We solve supply equal demand to find Ps for s = H , L.
Asset Markets and Liquidity Model
Chapter 5 - Banks,
With financial itermediaries (banks) consumers are able to consume
more:
d if incentive constraint holds
▶ c1s = .
y + (1 − y)P otherwise
s
y + (1 − y)Ps − λs d if incentive constraint holds
▶ c2s = (1 − λs ) · ps .
y + (1 − y)Ps otherwise
▶ The bank takes P = (PH , PL ) as given and chooses (d, y) to
maximize the expected utility U (c1H , c2H , c1L , c2L ) =
π · λH · u(c1H ) + π · (1 − λH ) · u(c2H )+
(1 − π) · λL · u(c1L ) + (1 − π) · (1 − λL ) · u(c2L )
Asset Markets and Liquidity Model
Chapter 5 - Banks,
In state s banks will be able to avoid a bank-run if and only if late
consumers lack the incentive to withdraw earlier (at t = 1), this happens
only when
y > λ s · d ⇒ Ps = R
y ≤ λ s · d ⇒ Ps ≤ R
Behavior in the asset market
continuation
Because (in the no default case) banks are choose the same
strategy (d, y). No banks can ever be short of cash at state s
because if one bank has to liquidate (forced to sell) some of the
long asset, then all banks will be selling (and none will be
buying) so the price would fall to Ps = 0. But if the price of the
long-asset is zero in any state, then in period t = 0, any bank
should invest all in the short-asset and buy an infinite amount
of the long-asset in period t = 1 in the state where Ps = 0. But
all banks doing this cannot be part of an equilibrium...
Behavior in the asset market
no default, continuation
So we have that y > λL · d ⇒ PL = R and y = λH · d.
Why y = λH · d? Because if y > λH · d then we would have
excess liquidity in both states but then then bank would be able
to reduce its position in the short-asset without compromising
its ability to pay depositors. Alternatively if y < λH · d then the
bank would need to (partially) divest from the long-asset but
because all banks are using the same strategy this can not
happen as we pointed before.
Now remember that when we solved for y and d in bank
problem we take PH and PL as given so both y and d are
functions of (PH , PL ) = (PH , R). We can use this to find the
value of PH by solving:
( )
y y
U( , y) =(π · λH + (1 − π) · λL ) · u +
λH λH
( )
y + (1 − y)PH − λH λyH
+ π · (1 − λH ) · u +
(1 − λH ) · pH
( )
y + (1 − y)R − λL λyH
+ (1 − π) · (1 − λL ) · u
(1 − λL ) · 1
The Optimal Deposit Contract
no default, continuation
∂ ∂ y ∂
We now solve d
dy U = U· λ + U = 0 for y ...
∂d ∂y H ∂y
Asset Markets again!
no default, continuation
( )
U B (d B , y B ) =(π · λH + (1 − π) · λL ) · u d B +
( B )
y + (1 − y B )PH − λH d
+ π · (1 − λH ) · u +
(1 − λH ) · PH /R
( B )
y + (1 − y B )PH − λL d
+ (1 − π) · (1 − λL ) · u
(1 − λL ) · PL /R
( )
U A (d A , y A ) =(1 − π) · λL · u d A +
( )
+ π · u y A + (1 − y A )PH +
( A )
y + (1 − y A )PL − λL d A
+ (1 − π) · (1 − λL ) · u
(1 − λL ) · PL /R
Asset Markets and Liquidity, Chapter 5
Default Scenario
where C = c1 + c2 .
If ps < 1 banks are not willing to carry cash from date 1 into
date 2.
Asset Markets and Liquidity, Chapter 5
Default Scenario