Liquidity and Asset Pricing (Prof. Pedersen) Short Sale Constraints Due to Limited Commitment

In the first module of this class we will study asset pricing implications of recursive contract theory. I will start by reviewing asset pricing in complete markets. Chapter 8 in Ljungqvist and Sargent (2004) provides background reading. The main topic of this module is asset pricing in an environment with limited commitment. As in the complete markets environment, agents can still trade a complete set of contingent claims. However, we assume that they can walk away from their debts. If they do so, they are excluded from trading forever.1 The inability of agents to commit leads to endogenous restrictions on trading. We will start by characterizing Pareto-efficient allocations. Then, we will study the Kehoe and Levine (1993) decentralization, where all trade takes place at time zero. Finally we will study a decentralization with sequential trade due to Alvarez and Jermann (2000). Complete markets models imply perfect risk-sharing: An agent’s individual consumption growth does not depend on its individual income growth, only on aggregate consumption growth. However, both consumption data and asset pricing data reveal that households are unable to trade away all of their idiosyncratic risk.2 The limited commitment model reproduces this ∗NYU Stern Finance. [email protected]. 44 West Fourth Street, Tisch 9-14. I thank Hanno Lustig for providing me with his teaching materials. This is the standard punishment in the literature, see Kehoe and Levine (1993), Kehoe and Perri (2002), Krueger and Perri (2003), etc. Lustig (2003) and Lustig and VanNieuwerburgh (2004b) propose a different outside option, where agents retain access to credit markets but loose all collateral assets. Papers find evidence at the household level (e.g. Cochrane (1991), Mace (1991), Nelson (1994),Krueger (2000), Blundell, Pistaferri and Preston (2002)), at the regional level (e.g. Hess and Shin (1998) and Lustig and VanNieuwerburgh (2004a)), and at the international level (e.g. Backus, Kehoe and Kydland (1992)).