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The authors analyze the equilibrium effects of non-tradable assets on optimal policy portfolios. They study how the existence of non-tradable assets impacts optimal asset allocation decisions of investors who own such assets and of investors who do not have access to non-tradable assets.

In this theoretical analysis, the authors analyze a model with tradable and non-tradable asset classes whose cash flows are jointly normally distributed. There are two types of investors, with and without access to non-tradable assets. All investors have constant absolute risk aversion preferences. The authors derive closed form solutions for optimal investor demand and equilibrium asset prices. They calibrated the model using US data for listed equity, bonds and private equity. Further, the authors illustrate the sensitivities of quantities and prices with respect to the main parameters.

The study finds that the existence of non-tradable assets has a large impact on optimal asset allocation. Investors with (without) access to non-tradable assets tilt their portfolios of tradable assets away from (toward) assets to which non-tradable assets exhibit positive betas.

The model provides important insights not only for investors holding non-tradable assets such as private equity but also for investors who do not have access to non-tradable assets. Investors who ignore the effect of non-tradable assets when reverse-engineering risk premia from asset covariances and market capitalizations might severely underestimate the equity risk premium.

The authors provide the first comprehensive analysis of the equilibrium effects of non-tradability of some assets on optimal policy portfolios. Thus, this paper goes beyond analyzing the effects of market imperfections on individual portfolio choices.

This article models debt market equilibrium given an expanded notion of rational behavior. The model extends Diamond's model of reputation acquisition, by assuming that some prospective borrower‐investors are opportunistic utility maximizers, while others are unwilling to mislead borrowers as to their intended use of borrowed funds. We find that the presence of honest borrowers is necessary to the function of debt markets, and that, as in real‐world markets, opportunistic and honest agents can coexist. We further find that total economic activity is positively correlated to the proportion of trustworthy agents. A major research concern in financial economics is the reconciliation of observed behavior with the predictions of the perfect‐markets, utility‐maximization models, which have traditionally supplied the dominant paradigm in finance. The main focus of recent research has been on the predictions of Agency Theory, or simply Agency (Jensen and Meckling, 1976). Agency has its origins in the property rights literature of economic theory (Alchian, 1969) and, in essence, addresses the following question: How do rational agents act in imperfect markets? A whole range of market imperfections have been analyzed ranging from the simplest type of moral hazard and adverse selection (Thakor, 1989) to the debt capacity of an industry (Maksimovic and Zechner, 1991). Indeed, few if any areas of business theory have escaped Agency's scrutiny; it has, in effect, recast the theory of the firm. In this light, the firm becomes a structure whose efficiency depends upon its ability to mitigate the costs associated with Agency. Firms are “legal fictions which serve as a nexus for a set of contracting relations among individuals” (Jensen and Meckling, 1976, p.310). One of the major gaps in the one‐period models of agency behavior has been the inability of these models to explain management's “honest” behavior (Thaler, 1992). That is, managers do not always engage in such “rational” acts as risk‐shifting, or paying excessive dividends, in order to enrich shareholders (and themselves) at the expense of bondholders. A significant move toward reconciling Agency's predictions with observed behavior has resulted from the reputation‐acquisition work of Diamond (1989), building on the work of Kreps and Wilson (1982) and Milgrom and Roberts (1982). In these models, agents acquire reputations by demonstrating some consistent mode of behavior through multiple iterations of a contractual situation. Through these iterations, principals modify their beliefs concerning the future behavior of the agent by observing certain outcomes. In Diamond's model, rational agents will not continually choose either a risky project or safe project. Their choice is a function of the interest rate and the stage of the game. Specifically, these agents choose the risky project initially; then, as attrition among risk‐takers causes interest rates to drop, they shift to the safe project for some iterations. As the end of the game approaches, however, these agents once again revert to investing in the risky project. In comparison with the attention that has been devoted to identifying and analyzing market imperfections, the former part of the Agency question — namely the “rational agents” part — has attracted much less attention in the finance literature. In Agency models, rationality has been defined strictly in terms of the individual pursuit of pecuniary wealth. This expected‐utility model has been tested experimentally and has been found to be systematically violated, in at least two fundamental ways: 1) Individuals do not behave as if they are attempting to maximize wealth (Plott, 1986), and 2) Individual behavior is affected by notions of fairness and cooperation (Kahneman, et al, 1986). Attempts to construct a theory of capital market behavior which can accommodate this observed behavior are virtually nonexistent. This lack is probably due to the presumption that opportunistic agents will drive ethical agents out of the market. However, as we demonstrate in the model developed in this paper, this is not necessarily the case. By focusing attention specifically on Agency's rationality premise, the model developed here differs from antecedent Agency models. This article investigates the implication, for financial‐market equilibra, of an alternative rationality premise. We assume that some agents will display the virtues of honesty and trustworthiness in their dealings with Other agents. Modifying Diamond's (1989) model of reputation acquisition in debt markets, the impact of these ‘virtuous’ agents on financial‐market equilibria is investigated. The model indicates that the existence of trustworthy agents in financial markets is not merely desirable from an economic perspective, but actually is essential if debt markets are not to fail. Specifically, if lenders do not belief that some non‐trivial cohort of trustworthy agents exists, then lenders cease to lend and debt markets cease to function. Also, the greater the proportion of honest agents, the greater is the overall level of economic activity; indeed, the existence of honest agents will tend to induce at least some of the opportunistic agents to act virtuously. We find that, as Bowie observes in a more general context, “[i]t only pays to lie or cheat when you can free ride off the honesty of others” (1991, pp.11–12). In addition, the belief in a non‐trivial cohort of trustworthy agents can lead to the elimination of some agency problems.