Endogenous Leverage in a Binomial Economy: The Irrelevance of Actual Default

43 Pages Posted: 22 Sep 2012

See all articles by Ana Fostel

Ana Fostel

University of Virginia

John Geanakoplos

Yale University; Santa Fe Institute

Multiple version iconThere are 2 versions of this paper

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

Fostel, Ana and Geanakoplos, John D, Endogenous Leverage in a Binomial Economy: The Irrelevance of Actual Default (September 21, 2012). Midwest Finance Association 2013 Annual Meeting Paper, Available at SSRN: https://ssrn.com/abstract=2150379 or http://dx.doi.org/10.2139/ssrn.2150379

Ana Fostel (Contact Author)

University of Virginia ( email )

1400 University Ave
Charlottesville, VA 22903
United States

John D Geanakoplos

Yale University ( email )

30 Hillhouse Avenue
New Haven, CT 06511
United States
203-432-3397 (Phone)

HOME PAGE: http://https://economics.yale.edu/people/faculty/john-geanakoplos

Santa Fe Institute ( email )

1399 Hyde Park Road
Santa Fe, NM 87501
United States

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