
On the Welfare Role of Redundant Assets with Heterogenous Forecasts
Abstract
We study a mutiperiod model with a nominal bond that matures in one period and identify the set of efficient allocations that can be sustained as Walrasian equilibria with heterogenous forecasts. We next add a long maturity bond, which under perfect foresight would be a redundant asset, and show that it fundamentally expands the set of efficient allocations that can be sustained as Walrasian equilibria. Indeed all wealth transfers compatible with efficiency can arise endogenously. The key feature driving this conclusion are forecasting errors, which lead to ex post arbitrage opportunities that induce these income transfers. (JEL classification numbers: D51, D53, D61)
Introduction
No arbitrage conditions play a fundamental role in the way assets are priced and therefore are instrumental in deciding the set of allocations that can be generated by Walrasian markets. The axiom of perfect foresight is built into the methodology most frequently used to price assets. This paper investigates the allocational implications of relaxing perfect foresight in a model where a short term bond coexists with a longer maturity bond, where the latter under perfect foresight would be a redundant asset. Forecasts are required to satisfy no arbitrage conditions so that market equilibrium is well defined in each period. However, due to errors in forecasting, there may exist arbitrage possibilities in an ex post sense, which allows the presence of the long term bond to expand significantly the set of intertemporally efficient allocations that can be sustained as Walrasian equilibria.
WP046