Incomplete-Market Equilibria Solved Recursively on an Event Tree

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

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Andrew Lyasoff

Finance

Authors: Bernard Dumas and Andrew Lyasoff
(forthcoming in Journal of Finance)

Because of non-traded human capital, real-world financial markets are massively incomplete. The modeling of imperfect, dynamic financial markets is a wide-open and difficult field, as yet barely ploughed. Following Cox, Ross and Rubinstein (1979), who calculated the prices of derivative securities on an event tree by simple backward induction, we show how a similar formulation can be utilized in computing heterogeneous-agents, incomplete-market equilibrium prices of primitive securities. Extant methods work forward and backward, requiring a guess of the way investors forecast the future. In our method, the future is part of the current solution of each backward time step.