INTRODUCTION

At first sight, the two papers in this section seem unrelated. The one by John Geanakoplos is about the role of collateral in explaining liquidity crises and crashes. Andrew Lo and Jiang Wiang's paper is concerned with a theoretical and empirical analysis of trading volume. However, on closer inspection, they have important interrelationships and provide an interesting contrast. They both trace their intellectual roots back to the Arrow–Debreu model, yet they represent two very different approaches to financial economics, both of which are widely used.

The papers investigate deviations from the standard perfect-markets assumption. Frictions are incorporated in a different way, though. In the Geanakoplos paper, the problem is preventing default, and collateral is the way this is achieved. In the Lo and Wang paper, there are asymmetric information and fixed transaction costs. What is more important is that the motivations for trade are quite different. In the Geanakoplos paper, it is differences in beliefs; in the Lo and Wang paper, it is different shocks to nonfinancial income. Both of these assumptions are crucial to the results the authors obtain. They represent quite different traditions.

The Geanakoplos paper is a mainstream general equilibrium paper. In the Arrow–Debreu model, the possibility of differences in preferences is an important component of the model. Because beliefs are embedded in preferences, allowing different beliefs is a standard assumption.

In finance, and in particular in asset pricing, allowing different beliefs is currently viewed as a nonstandard assumption.