Endogenous Leverage in a Binomial Economy: The Irrelevance of Actual Default
43 Pages Posted: 22 Sep 2012
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Endogenous Leverage in a Binomial Economy: The Irrelevance of Actual Default
Date Written: September 21, 2012
Abstract
We show that binomial economies with financial assets are an informative and tractable model to study endogenous leverage and collateral equilibrium: endogenous leverage can be highly volatile, but it is always easy to compute. The possibility of default can have a dramatic effect on equilibrium, if collateral is scarce, yet we prove the No-Default Theorem asserting that, without loss of generality, there is no default in equilibrium. Thus potential default has a dramatic effect on equilibrium, but actual default does not. This result is valid with arbitrary preferences, contingent promises, many assets and consumption goods, production, and multiple periods. On the other hand, we show that the theorem fails in trinomial models. For example, in a CAPM model, we find that default is robust. In a model with heterogeneous beliefs, we find that different agents might borrow on the same asset with different LTV s.
Keywords: Endogenous Leverage, Collateral Equilibrium, Default, Financial Asset, Binomial Economy, VaR
JEL Classification: D52, D53, E44, G01, G11, G12
Suggested Citation: Suggested Citation