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Collateral or utility penalties?
Author(s) -
Maldonado Wilfredo L.,
Orrillo Jaime
Publication year - 2007
Publication title -
international journal of economic theory
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.351
H-Index - 11
eISSN - 1742-7363
pISSN - 1742-7355
DOI - 10.1111/j.1742-7363.2007.00049.x
Subject(s) - collateral , economics , collateralized debt obligation , general equilibrium theory , converse , incomplete markets , microeconomics , competitive equilibrium , welfare , economy , mathematical economics , finance , market economy , geometry , mathematics
In a two‐period economy with incomplete markets and possibility of default we consider the two classical ways of enforcing the honoring of financial commitments: by using utility penalties and by using collateral requirements that borrowers have to fulfill. First, we prove that any equilibrium in an economy with collateral requirements is also an equilibrium in a non‐collateralized economy where each agent is penalized in their utility if his or her delivery rate is lower than the payment rate of the financial market. Second, we prove the converse: any equilibrium in an economy with utility penalties is also an equilibrium in a collateralized economy. For this to be true, the payoff function and initial endowments of the agents must be modified in a quite natural way. Finally, we prove that the equilibrium in the economy with collateral requirements attains the same welfare as in the new economy with utility penalties.