Economics of Uncertainty and Information

Charles Roddie (cr250@cam.ac.uk)

February 1, 2013

Part IIb: Complete financial markets

The choice of portfolio allocation to a risky and risk free asset is an example of an
incomplete market.
If you liked the risky asset X but wanted to guarantee yourself a minimum return,
you might want to buy an asset Y where Y = max (X , 0), but you cannot because the
market is not complete.
Complete markets allow purchase of state-contingent securities
You can purchase any state contingent wealth, i.e. random variable X () - provided you can afford it.
States are called scenarios in some financial analysis.
The simplest state-contingent securities are Arrow-Debreu securities.
There is one of these for each state i , and it pays 1 in state w i and 0 otherwise.
These are the elementary securities, out of which any state-contingent wealth
and trades can be constructed.
* The random variable X is composed of X (1 ) units of the A-D security for
state 1 , X (2 ) units of the A-D security for state 2 , and so on.
Complete markets do not exist, but as more types of financial assets and derivatives
are introduced, financial markets become more complete

1 Preferences over contingent consumption

Suppose consumption is a RV, equal to x 1 , x 2 . . . x n depending on the state, and preferences are EU:

p i u (x i )

 Here we ask: What do these preferences look like as functions of the x i ?

P
Write U (x 1 , . . . x n ) = p i u (x i ). This is the utility function over (x 1 , . . . x n ).
What is the marginal rate of substitution between consumption (wealth) in state i
and consumption in state j ?
MRSi , j = Ui /U j =
If x i = x j , this is

p i u 0 (x i )

p j u0 x j

pi
pj

1.1 Two-state diagrams

Two states. Preferences given by U (x 1 , x 2 ) depend on probabilities and u.
If p 1 = p 2 , indifference curves are symmetric about x 1 = x 2 .
If p 1 < p 2 , wealth in state 1 is less valuable than wealth in state 2.

ind. curves
2

2
1 = 2

1 = 2

1
gradient 1 /2

gradient 1

Figure 1: Indifference curves of U (x 1 , x 2 ). Left: p 1 = p 2 = 12 . Right: p 1 < p 2 .

Stochastic dominance gives an indication of what indifference curves will look like
(assuming u 0 > 0, u 0 < 0)

1 = 2

2
gradient 1 /2

These points
dominate (FSD)

These points
dominate (SSD)

1 , 2
1

Figure 2: FSD and SSD

Different levels of risk aversion

10

10

0
0

(a) R = 2; p 1 =

10

1
2

(b) R = 2; p 1 =

10

10

10

1
4

0
0

(c) R =

1
2;

p1 =

10

1
2

(d) R =

1
2;

p1 =

10

1
4

Figure 3: CRRA preferences with different R , different p 1

2 An exchange economy with Arrow-Debreu securities

Financial markets allow:
Trading of wealth across states (trading of risk)
Trading of wealth across time (borrowing and lending)
Participation in risky investments
We will study just the first one now, considering
an exchange economy (no production)
with one consumption stage
* Consumption takes place after trading, and depends on the state
This works exactly like a real exchange economy, except instead of
x 1 = oranges, x 2 = lemons, x 3 = bells..., we have:
x 1 = state 1 wealth/consumption; x 2 = state 2 wealth; x 3 = state 3 wealth....
So you should be very familiar with the setup:
Consumers A, B,C , . . .

Endowments e A = e 1A , e 2A , . . . , e B = e 1B , e 2B , . . . ,...
A
B
* Total endowment e := e + e +

vNM utility u A , u B , . . .
Giving utility U A (x 1 , x 2 , . . . ) =

p i u A (x i ), U B = . . .

And also familiar with equilibrium and how to find it:

Prices q = q 1 , q 2 , . . .
P
P
P
Budget sets q i x iA = q i e iA , q i x iB = . . .

Optimal choice x A q = x 1A q , x 2A q , . . . , x B q = . . .
A
B
* This is unique because U ,U , . . . are strictly concave.
p i u 0 (x i )
* Satisfies MRS vector q, equivalently MRSi , j = p j u 0 (x j ) =


Equilibrium q has x A q + x B q + = e.

qi
qj

* If there are n states, only need to check n 1 of them, by Walras law

And familiar with the Pareto efficiency properties:

 First welfare theorem: exchange equilibrium is Pareto efficient

Second welfare theorem: any Pareto efficient point is supported as an exchange
equilibrium for some prices
Contract curve: the set of Pareto efficient points
B
A
* Given by setting MRSi j = MRSi j = . . .

2.1 Scarcity and prices

q

The MRS condition implies that if q i = p i , then all consumers will choose x i = x j ,
j
j
and eliminate risk between states i and j .
If

qi
qj

So if

<
qi
qj

pi
pj

, then x i > x j , and If

<

pi
pj

qi
qj

>

pi
pj

, then x i < x j

, total demand x iA + x iB + > x jA + x Bj + , and similarly for

qi
qj

>

pi
pj

Total demand in equilibrium equals the endowments.

So if wealth is scarce in total in state i than in state j , in equilibrium the relative price
will be higher than the fair ratio of probabilities:
If e i = e j we must have

qi
qj

pi
pj

If e i > e j we must have

qi
qj

<

pi
pj

If e i < e j we must have

qi
qj

>

pi
pj

2.2 Edgeworth box

The simplest setting of an Arrow-Debreu economy has two states.
Shouldnt a complete market have a very large number of states?
The two-state setting is illustrative.
In a few situations, there can be two relevant states. E.g. loss/no loss as in the
basic insurance model.
The Edgeworth box:


2
equilibrium

1
Figure 4: Equilibrium in the Edgeworth box

One can also draw the contract curve as usual

2.3 Production
We can also think about what will be produced under complete financial markets.
For example investing in an aircraft may well generate profits when wealth is plentiful (good economy state) and losses when it is not (bad economy state).
The investment shouldnt be evaluated according to the expected profit (risk neutrality) or to any given utility function (risk aversion), but profits in the good state
should be weighted by qG and losses weighted by q B .
But these prices depend on equilibrium, so on preferences.
We shall have more definite things to say about this under incomplete markets using
stronger assumptions (mean-variance analysis).