Financial economics of imperfect markets
My dissertation focuses on imperfections that exist in the real economy and how financial instruments can alleviate inefficiencies caused by these imperfections. I also focus on the pricing of these instruments. The first topic I discuss is the pricing of defaultable securities in a general equilibrium context. It has been argued previously that the trading of these securities in incomplete markets may lead to gains in social efficiency by enabling better allocations. In the first chapter, default risk is priced as a credit spread in terms of an aggregate component (which in this case is credit quality), and some interesting properties of default and recovery rates in equilibrium are demonstrated. CAPM-type equilibrium bounds on credit spreads are developed. The topic ends with a discussion of financial contagion and how this risk may also be priced. The second chapter discusses a different form of market imperfection. Here, the markets are complete, but agents are strategic, and are no longer price taking. Agents take into account the effect of their trade size on the price they receive in the market. It is well known that under such circumstances, agents trade to a Nash equilibrium that is not Pareto optimal. Mechanisms, such as myopic re-trading, have been proposed that allow agents to reach the Pareto optimum allocation via multiple rounds of trading. Using a specialized model, I demonstrate the potential for using financial instruments in alleviating the allocative inefficiency arising from agents' strategic behavior. It is optimal for the agents in the economy to participate in this market, and to trade to the Pareto optimal allocation. This happens in just one round of trading, and the results hold irrespective of the size of the markets.
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