Survival, Arbitrage, and Equilibrium with Financial Derivatives in Constrained Asset Markets

Abstract

Survival conditions ensure the presence of consumptions that cost less than the total contingent income of agents in general equilibrium models. These conditions are generally fulfilled in competitive equilibrium. This paper shows the existence of equilibrium for incomplete market economies where individuals' asset holdings are subject to portfolio constraints by introducing a new survival condition. Based

on McKenzie's irreducibility assumption, Gottardi and Hens (1996 ) provide the GEI irreducibility condition for the existence of equilibrium in unconstrained asset markets. The GEI irreducibility condition, however, leaves no room for redundant assets such as financial derivatives simply because they do not contribute to the creation of risk-sharing opportunities in unconstrained asset markets. Thus, such condition is no longer valid in constrained asset markets where redundant assets are empowered to affect the financial ability of agents to possess `cheaper' consumptions in equilibrium. This paper extends the irreducibility assumption of Gottardi and Hens (1996) to constrained

asset markets by considering the capability of financial derivatives to create intertemporal income transfers.