Asset Pricing Bubbles and Portfolio Constraints—Dynamic Equilibrium with Heterogeneous Agents and Risk Constraints

in Developments in Finance and Accounting, Research Day
May 14th, 2012

Rodolfo Prieto

Rodolfo Prieto

Finance

Author: Rodolfo Prieto

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. In contrast to previous results in the literature, we show that the imposition of constraints dampens fundamental shocks, challenging the notion that risk management rules amplify aggregate fluctuations. We also show that risk constraints may give rise to bubbles in asset prices, and connect these results to portfolio imbalances generated by the constraints and the heterogeneity across agents.