Dynamic Equilibrium with Heterogeneous Agents and Risk Constraints

Abstract

We examine the impact of risk-based portfolio constraints on asset prices in an exchange economy. Constrained agents scale down their portfolio and behave locally like power utility investors with risk aversion that depends on current market conditions. The imposition of constraints dampens fundamental shocks, challenging studies that suggest that risk management rules amplify aggregate fluctuations. Constraints may give rise to bubbles, whose emergence is associated to the risk aversion distribution across agents and the severity of the risk constraints.

Keywords: Asset pricing bubbles, Endogenous regimes, General equilibrium, Risk constraints, Stochastic volatility

JEL Classification: D51, D52, D53, G11, G12