Three essays in financial economics under asymmetric information

This dissertation consists of three essays. The essay "On the Optimal Allocation of New Security Listings to Specialists" addresses the question of how securities with correlated payoffs should be optimally allocated to dealers in a specialist system. Using an adverse selection model with risk averse traders, I compare different market-making scenarios and derive equilibrium prices in closed form. I demonstrate that specialists are always better off when their assets are highly correlated, and provide conditions under which investors prefer such a situation as well. Intuitively, this is the case when the investors' expected endowment shocks are large; specialists are sufficiently risk averse, and the competition between specialists is weak. The essay "The Disposition Effect: A Rational Perspective" demonstrates that the disposition effect, i.e., the tendency of investors to sell winning investments too soon and hold losing investments too long; is not intrinsically at odds with rational behavior. Specifically, I show (i) that disposition effects arise quite naturally in a world with changing information asymmetry, (ii) that existing empirical tests rejecting an information-based explanation are inconclusive, and (iii) that disposition effects are consistent with price momentum. The essay "Managerial Compensation, Market Liquidity, and the Overinvestment Problem" investigates the relationship among a firm's managerial incentive scheme, the market liquidity of its shares, and its investment policy. It shows that the shareholders' concern about the effectiveness of stock-based compensation can lead to overinvestment. However, unlike other explanations in the literature, my results are not caused by suboptimal incentive contracts, nor do they rely on the assumption that managers are "empire-builders". Rather, overinvestment serves to induce information production by outside investors. By accepting positive as well as negative NPV projects, a firm effectively increases the market's uncertainty about its cash flow; which gives traders more incentives to become informed. The increased information flow into the market improves the informativeness of the stock price and, thus, enables shareholders to design more efficient managerial compensation contracts.