Survival, Arbitrage, and Equilibrium with Financial Derivatives in Constrained Asset Markets

Guangsug Hahn ; Dong Chul Won

Associate Professor, Division of Humanities and Social Sciences, POSTECH, San 31, Hyoja-dong, Nam-gu, Pohang 790-784, Korea, Tel: +82-54-279-2032, Fax: +82-54-279-3699 econhahn@postech.ac.kr
Corresponding Author, Professor, College of Business Administration, Ajou University, Woncheon-dong, Yeongtong-gu, Suwon 443-749, Korea, Tel: +82-10-3133-0334, Fax: +82-31-219-1616 dcwon@ajou.ac.kr

JEL Classification: C62, D52, G10

Abstract

Survival conditions ensure the presence of consumptions that cost less than the total contingent income of agents in general equilibrium models. These conditions are generally fulfilled in competitive equilibrium. This paper shows the existence of equilibrium for incomplete-market economies where individuals' asset holdings are subject to portfolio constraints by introducing a new survival condition. Based on McKenzie's irreducibility assumption, Gottardi and Hens (1996 ) provide the GEI irreducibility condition for the existence of equilibrium in unconstrained asset markets. The GEI irreducibility condition, however, leaves no room for redundant assets such as financial derivatives simply because they do not contribute to the creation of risk-sharing opportunities in unconstrained asset markets. Thus, such condition is no longer valid in constrained asset markets where redundant assets are empowered to affect the financial ability of agents to possess `cheaper' consumptions in equilibrium. This paper extends the irreducibility assumption of Gottardi and Hens (1996) to constrained asset markets by considering the capability of financial derivatives to create intertemporal income transfers.

Keywords:

Equilibrium, Portfolio constraints, Redundant assets, Incomplete markets, Arbitrage, Irreducibility, Survival conditions

Acknowledgments

This work was supported by the National Research Foundation of Korea Grant funded by the Korean Government (NRF-2010-32A-B00040). The authors are grateful to the referees for helpful comments.

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