Valuing government obligations when markets are incomplete
Kotlikoff, Laurence; Hashanhodzic, Jasmina
This paper posits and simulates a ten-period overlapping generations model with aggregate shocks to price safe and risky government obligations using consumption-asset pricing. Agents can’t trade with future generations to hedge the model’s productivity and depreciation shocks, and can only invest in one-period bonds and risky capital. We find that the pricing of short- and long-dated riskless obligations is anchored to the prevailing one-period risk-free return. The prices of obligations whose values are proportional to the prevailing wage are essentially identical to those of safe obligations, notwithstanding large macro shocks. On the contrary, government obligations provided in the form of options entail significant risk adjustment. We also show that the value of obligations to unborn generations depends on the nature of the compensating variation. Our model suggests the potential of CGE OLG models to price government obligations and non-marketed private securities in the presence of incomplete markets and macro shocks.
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