Pietro Dindo

Both portfolio insurers and constant weight traders investment strategies survive for low expected log returns of risky assets and dominate on different paths for high expected log returns

This paper studies the impact of financial sector size and leverage on business cycles and risk-free rates dynamics. We model a general equilibrium productive economy where financial intermediaries provide costly risk mitigation to households by pooling the idiosyncratic risks of their investment activities. We find that leverage amplifies variations of intermediaries’ relative size, but may also mitigate the business cycle. Moreover, it makes risk-free rates pro-cyclical. Households benefit the most when the financial sector is neither too small, thus avoiding high consumption fluctuations and costly mitigation, nor too big, so that fewer resources are lost after intermediation costs.

Within a financial market where a risk-free bond and a long-lived risky asset are exchanged by investors with heterogeneous trading rules, we assume that the investors most exposed to the risky asset are subject to joint liquidation needs. The latter encompass a risk whenever the market impact of traders subject to them is large enough, due to a fire-sale phenomenon. Our aim is to provide conditions for the transformation of liquidation needs into liquidation risk, and to characterize the resulting asset price dynamics. We find that when the average position of traders subject to liquidation needs is lower than the position of the other traders, the former vanish and asset prices are driven solely by the dividend process. Whether liquidation risk becomes systemic or its impact is mitigated by the position of other traders, depends on the relative wealth dynamics. We provide conditions on agents positions under which the liquidation risk is always systemic because the aggressive traders dominate, as well as conditions under which the size of the liquidation risk is endogenously determined because all traders survive and the relative wealth dynamics is a mean reverting process.

We consider an exchange economy with heterogeneous agents and multiple assets and investigate the coupled dynamics of assets’ prices and agents’ wealth. We assume that agents have heterogeneous beliefs and invest on each asset a fraction of wealth proportional to its expected dividends. Our main finding is that long-run coexistence of heterogeneous agents is a generic outcome of the market dynamics. We provide sufficient conditions for the latter, as well as sufficient conditions for the relative wealth of any given agent converging to zero or to one. Since we use a direct approach that combines the inter-temporal dynamics of wealth and prices via agents’ portfolio rules, we can characterize when long-run heterogeneity occurs for both complete and incomplete asset markets.

In a stochastic exchange economy where, due to beliefs’ heterogeneity, agents engage in speculative trade, I investigate the Market Selection Hypothesis that speculation rewards the agent with the most accurate beliefs. Assuming that markets are complete, I derive sufficient conditions for agents’ survival in terms of saving and portfolio decisions and use them to show that the Market Selection Hypothesis fails generically. In particular, when agents have Epstein-Zin preferences, beliefs heterogeneity may persist in the long-run or speculation may cause the agent with the most accurate beliefs to vanish. Failures occur because agents’ portfolio average returns are shown to depend not only on beliefs’ accuracy but also on risk preferences, through the comparison with the growth-optimal portfolio. Failures do not occur in bounded CRRA economies because, due to the interdependence of relative risk aversion and intertemporal elasticity of substitution, portfolio returns not related to beliefs’ accuracy are compensated by the component of saving that responds to uncertainty.