Collateralization, Market Incompleteness and Asset Overvaluation

Abstract

We study a simple static economy with collateralized loan contracts and an incomplete asset market. We study whether economic forces operate to keep asset price equal to fundamentals in this economy. We find that asset prices may be higher than the valuation of any agent in the economy, i.e., the price of an asset is higher than the present value of its cash flows. Such overvaluation may arise from risk sharing activities simply due to market incompleteness, and does not require any other extra conditions such as heterogeneous beliefs or informational frictions.

Keywords: collateral, overvaluation, incomplete market, secured loan, tranche

JEL Classification: D52, D53, G12, G13, G21