WP 2012-04 Martingale properties of self-enforcing debt

Posted On January 4, 2012
Categories Working Papers, WP 2012

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ABSTRACT. Not-too-tight (NTT) debt limits are endogenous restrictions on debt that prevent agents from defaulting and opting for a specified continuation utility, while allowing for maximal credit expansion (Alvarez and Jermann 2000). For an agent facing some fixed prices for the Arrow securities, we prove that discounted NTT debt limits must differ by a martingale. Discounted debt limits are submartingales/martingales under an interdiction to trade/borrow, and can be supermartingales under a temporary interdiction to trade. With high interest rates and borrowing limited by the agent’s ability to repay debt out of his future endowments, nonpositive NTT debt limits are unique. With low interest rates, bubbles limited by the size of the total martingale components in debt limits can be sustained in equilibrium. Bubbles arise in response to debt limits more restrictive (at the prevailing interest rates) than the total amount of self-enforcing debt allowed by the underlying enforcement limitations.