We study a two-period general equilibrium model with incomplete asset markets and default. We make collateral endogenous by allowing each seller of assets to fix the level of collateral. Sellers are required to provide collateral whose first-period value, per unit of asset, exceeds the asset price by an arbitrarily small amount. Moreover, borrowers are also required to be fully covered by the purchase, in the first period, of state-by-state default insurance. These insurance contracts are offered by lenders. The insurance cost or revenue is a linear charge and plays the role of a spread penalizing borrowers who will incur in default and benefiting lenders who will suffer default. Under these assumptions, equilibrium always exists. Copyright Blackwell Publishers, Inc. 2000.
This paper shows the existence of equilibrium and its non-triviality (i.e. there exist, in all periods, both trade and default in the security markets) in an overlapping generation model with incomplete markets. This result is obtained by assuming that agents in the economy exhibit two-sided altruism in the following way: each agent may leave a financial inheritance to his only offspring (forward altruism) in the last period of his life, and in the same period, the descendant may accumulate debts in the name of the agent i.e., the father (backward altruism). Thus, if the descendant does not honor the commitment acquired in the name of his antecessor, he will suffer penalties in his utility function. To avoid the excessive issuance of debt, we shall suppose that the agent (the father) suffers a disutility in proportion to the net value of the debt left to his descendant (the son).
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