Wilfredo L. Maldonado acknowledges CNPq of Brazil for financial support 300059/99-0(RE) and Jaime Orrillo acknowledges CNPq for financial support 301218/2004-8. The authors acknowledge the comments of Mário Páscoa and the valuable suggestions provided by an anonymous referee.
Collateral or utility penalties?
Article first published online: 6 JUN 2007
International Journal of Economic Theory
Volume 3, Issue 2, pages 95–111, June 2007
How to Cite
Maldonado, W. L. and Orrillo, J. (2007), Collateral or utility penalties?. International Journal of Economic Theory, 3: 95–111. doi: 10.1111/j.1742-7363.2007.00049.x
- Issue published online: 6 JUN 2007
- Article first published online: 6 JUN 2007
- Accepted 6 February 2007
- incomplete markets;
- exogenous collateral;
- utility penalties
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.