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Rev Fin 2000; 13:715-748
© 2000 the Society for Financial Studies

Article

Equilibrium mispricing in a capital market with portfolio constraints

S Basak and B Croitoru1
University of Pennsylvania, USA
1 McGill University, Canada
Correspondence to: S Basak, Finance Department, The Wharton School, University of Pennsylvania, Philadelphia, PA 19104-6367, USA
e-mail: basaks@wharton.upenn.edu

Abstract

This article develops a general equilibrium, continuous time model where portfolio constraints generate mispricing between redundant securities. Constrained consumption-portfolio optimization techniques are adapted to incorporate redundant, possibly mispriced securities. Under logarithmic preferences, we provide explicit conditions for mispricing and closed-form expressions for all economic quantities. Existence of an equilibrium where mispricing occurs with positive probability is verified in a specific case. In a more general setting, we demonstrate the necessity of mispricing for equilibrium when agents are heterogeneous enough. The construction of a representative agent with stochastic weights allows us to characterize prices and allocations, given mispricing occurs.


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