Equilibrium of Financial Derivative Markets and Compensating Variations Under Portfolio Insurance Constraints

Abstract

This paper examines the equilibrium of portfolio under insurance constraints on the terminal wealth. We consider a single period economy in which agents search to maximize the expected utilities of their terminal wealths. Both partial and general optimal financial equilibria are determined and analyzed for quite general utility functions and insurance constraints. We introduce also the notion of compensating variation to quantify the monetary loss of not having the true optimal portfolio profile, for the clients and also for the bankers.This paper examines the equilibrium of portfolio under insurance constraints on the terminal wealth. We consider a single period economy in which agents search to maximize the expected utilities of their terminal wealths. Three main classes of financial assets are considered: a riskless asset (usually the bond), a risky asset (the stock) and European options of all strikes (corresponding to financial derivatives). Both partial and general optimal financial equilibria are determined and analyzed for quite general utility functions and insurance constraints. We introduce also the notion of compensating variation to quantify the monetary loss of not having the true optimal portfolio profile, for the clients and also for the bankers.