In the basic version of this model (see link below), both the short-term asset (deposit) and the long-term investment (“technology”) are considered to be risk-free (that is, there is only one possible “cash flow” or output outcome that occurs with 100% probability). In finance, when we talk about appropriate rates of return, we often say that illiquid stocks should offer a higher rate of return (e.g., because of transaction costs). In this model, the technology in a sense offers the risk free rate of interest. Why is this the case? Is this because at time 0 no one expects (in the payoff/return distribution) a bank run to occur? Therefore, even though the asset is illiquid, if it is sold at time 2, there is no transaction cost due to this illiquidity. If the asset is liquidated at time 1, then the liquidation value is lower than the “market” value. Why is this not accounted in the model at time 0? Is it because expectations change at time 1 when the run occurs (and therefore the payoff distribution)? Is this model a non-stationary process?




Your Answer

By clicking “Post Your Answer”, you agree to our terms of service and acknowledge you have read our privacy policy.