inducing liquidity in thin financial markets through combined value trading mechanisms asset pricing theory hypothesizes that investors are only interested in portfolios individual securities are evaluated only in terms of their contribution to portfolio risk and return yet standard financial market design is that of parallel unconnected markets whereby investors cannot submit orders in one market conditional on events in others when markets are thin this exposes them to substantial execution risk fear of ending up with unbalanced portfolios after trading may even keep investors from submitting orders further eroding liquidity and the ability of markets to equilibrate the suggested solution is a portfolio trading mechanism referred to as combined value trading cvt investors are allowed to submit orders for packages of securities and the system matches trades and computes prices by optimally combining portfolio orders in an open book we study the performance of the cvt mechanism experimentally and compare it to the performance of parallel unconnected double auctions in experiments with similar parametrization and either a similar number of subjects or substantially thicker markets we present evidence that our portfolio trading mechanism facilitates equilibration to the extent that the thicker markets do inspection of order submission and trade activity reveals that subjects manage to exploit the direct linkages between markets enabled by the cvt system

a liquidity based model of security design we consider the problem of the design and sale of a security backed by specified assets given access to higher return investments the issuer has an incentive to raise capital by securitizing part of these assets at the time the security is issued the issuer s or underwriter s private information regarding the payoff of the security may cause illiquidity in the form of a downward sloping demand curve for the security the severity of this illiquidity depends upon the sensitivity of the value of the issued security to the issuer s private information thus the security design problem involves a tradeoff between the retention cost of holding cash flows not included in the security design and the liquidity cost of including the cash flows and making the security design more sensitive to the issuer s private information we characterize the optimal security design in several cases we also demonstrate circumstances under which standard debt is optimal and show that the riskiness of the debt is increasing in the issuer s retention costs for assets

financial innovation in a general equilibrium model abstract we develop a model of financial innovation in which intermediaries can issue new financial securities against collateral in the form of standard securities intermediaries have to market their innovations and marketing is costly we show that the equilibrium asset structure may exhibit redundancies as frequently observed on financial markets we give conditions for efficiency of financial innovation and show that with small innovation costs the indeterminacy of equilibrium allocations has small utility consequences journal of economic literature classification numbers d52 g10

trying to explain home bias in equities and consumption investors hold a substantially larger proportion of their wealth portfolios in domestic assets than standard portfolio theory would suggest a phenomenon called equity home bias in the absence of this bias investors would optimally diversify domestic output risk using foreign equities therefore consumption growth rates would tend to co move across countries even when output growth rates do not empirically however consumption growth rates tend to have a lower correlation across countries than do output growth rates a phenomenon i call consumption home bias in this paper i discuss these two biases and their potential relationship as suggested by the literature

a pragmatic approach to capital account liberalization in the mid 1990s mainstream economists of nearly all stripes commonly recommended capital account liberalization that is allowing a free flow of funds in and out of a country s economy as an essential step in the process of economic development but then came the east asian financial crisis of 1997 98 in which even seemingly healthy and well managed economies like those of south korea were engulfed by massive capital outflows and tremendous currency volatility and capital account liberalization became quite controversial in the economics profession a decade later now that time has quelled passions and intervening research can shed more light on the debate it appears that both the costs and benefits of capital account liberalization may have been misunderstood in that earlier debate now it appears that the main benefits of capital account liberalization for emerging markets are indirect more related to their role in building other institutions than to the increased financing provided by capital inflows and these indirect benefits are important enough that countries should look for creative approaches to capital account liberalization that would help attain these benefits while reducing the risks countries don t have much choice but to plan for capital account liberalization because capital accounts are de facto becoming more open over time whatever governments may do to try to control them

general equilibrium with endogenously incomplete financial markets abstract the present paper studies a class of general equilibrium economies with imperfectly competitive financial intermediaries and price taking consumers intermediaries optimally choose the securities they issue and the bid ask spread they charge financial intermediation is costly and hence markets are endogenously incomplete an appropriate equilibrium concept is developed and existence is proved competitive equilibria for this class of economies display full indexation of securities payoffs and monetary neutrality even if intermediaries are restricted to issue nominal securities and financial markets turn out to be incomplete this is in sharp contrast with the indeterminacy and non neutrality results established in the literature for incomplete markets economies with exogenously given nominal securities journal of economic literaturclassification numbers d52 g20

the case for gdp indexed bonds gds indexed bonds this paper seeks to revive the case for countries to insure against economic growth slowdowns by issuing bonds indexed to the rate of growth of gdp we show that gdp indexed bonds could provide substantial benefits in reducing the likelihood of default crises and allowing countries to avoid pro cyclical fiscal policies we simulate the effects of gdp indexed bonds under different assumptions about fiscal policy reaction functions and their output effects and find that they could substantially reduce the likelihood of debt gdp paths becoming explosive the insurance premium would likely be small because cross country comovement of gdp growth rates is low and cross country gdp growth risk is thus largely diversifiable for an investor holding a portfolio of gdp indexed bonds potential obstacles to the emergence of a market for these bonds include the verifiability of gdp data the trade off between insurance and moral hazard and the need for liquidity theory and past experience suggest that financial innovation often requires official intervention and its timing and form are difficult to predict we discuss institutional fixes and suggest an approach for attempting to start up a market eduardo borensztein and paolo mauro

financial market innovation and security design an introduction abstract the article describes in the context of theory and practice this special issue of the journal of economic theory on financial market innovation and security design the main focus is on security design in incomplete financial markets possibly with asymmetrically informed traders we first survey the general equilibrium literature which emphasizes the spanning role of securities we then provide a unified framework encompassing the literature that employs a cara guassian setting to study the impact of financial innovation on risk sharing and information aggregation journal of economic literature classification numbers g10 d52

solving asset pricing models when the price dividend function is analytic we present a new method for solving asset pricing models which yields an analytic price dividend function of one state variable to illustrate our method we give a detailed analysis of abel s asset pricing model a function is analytic in an open interval if it can be represented as a convergent power series near every point of that interval in addition to allowing us to solve for the exact equilibrium price dividend function the analyticity property also lets us assess the accuracy of any numerical solution procedure used in the asset pricing literature

energy conservation policies in the oecd did they make a difference abstract in 1985 homes services automobiles truck freight air passenger traffic other transport and manufacturing in the oecd used 47 million bbl day of oil equivalent mb doe or 105 000 pj 1 between 1972 and 1985 however energy use per unit of activity in each of these sectors in the oecd fell significantly if these energy intensities by sector had been frozen at their 1972 values 1985 end use would have been close to 64 mb doe or 143 000 pj at the rates of activity that prevailed in each sector in 1985 2 the difference yields a saving of 17 mb doe the corresponding oil savings in this period amount to close to 12 mb doe including substitution by other fuels in this paper it is suggested that most of these savings will not reverse in the near time with lower oil prices only a small part was caused by energy conservation policies

optimal hedging and equilibrium in a dynamic futures market abstract this paper considers an agent maximizing the expected utility of the sum of the terminal value of a fixed portfolio of spot market assets and the terminal value of a margin account on a futures trading position closed form solutions for the optimal hedging strategy are provided in several special cases

information revelation and market incompleteness this paper introduces a theory of market incompleteness based on the information transmission role of prices and its adverse impact on the provision of insurance in financial markets we analyse a simple security design model in which the number and payoff of securities are endogenous agents have rational expectations and differ in information endowments and attitudes toward risk when markets are incomplete equilibrium prices are typically partially revealing while full relevation is attained with complete markets the optimality of complete or incomplete markets depends on whether the adverse selection effect the unwillingness of agents to trade risks when they are informationally disadvantaged is stronger or weaker than the hirshleifer effect the impossibility of trading risks that have already been resolved as new securities are issued and prices reveal more information when the hirshleifer effect dominates an incomplete set of securities is preferred by all agents and generates a higher volume of trade hirshleifer 1971 was the first to point out that revelation of information can reduce risksharing opportunities in insurance markets resulting in a welfare loss in this paper we build on hirshleifer s insight to develop a theory of endogenous market incompleteness we show that in an economy with asymmetric information in which agents learn from prices an incomplete financial structure may be optimal the reason is that less information is revealed by prices when markets are incomplete than in an otherwise identical economy with complete markets 1 paradoxically a greater degree of incompleteness may result in better risk sharing since the only risks that can be traded are those whose resolution is not common knowledge at the time of trade for the same reason incompleteness of markets may also foster a higher volume of trade the connection between security design asymmetric information trading volume and welfare in financial markets is a subtle one and it is important to isolate its various facets the efficacy of security markets in aggregating and transmitting private information depends on the characteristics of the financial structure and especially on the number of tradeable assets indeed within the rational expectations paradigm informational differences disappear in equilibrium generically when the price vector has

currencies and the allocation of risk the welfare effects of a monetary union in a general equilibrium model with incomplete asset markets nominal securities and mean variance preferences a monetary union is desirable when the gain from eliminating excess volatility of nominal variables exceeds the cost of reducing the number of currencies with which to hedge risks copyright 1998 by american economic association

optimal innovation of futures contracts this article presents a simple model of the innovation of new futures contracts by transaction volume maximizing futures exchanges in incomplete markets under uncertainty with mean variance preferences and proportional transactions costs we characterize the set of nash equilibria for a number of exchanges simultaneously or sequentially choosing contracts the optimal monopolistic contract design is shown to be pareto optimal an example shows the failure of pareto optimality for aparticularnash equilibrium likewise in a monopolistic multiperiod setting an example shows the failure of pareto optimality given an incentive for the exchange to induce turnover

why do stocks and consumption imply such different gains from international risk sharing abstract estimates of the gains to international risk sharing based upon stock returns tend to find dramatically higher gains than do estimates from consumption based models in this paper i examine the reasons for these differences using a common theoretical framework for both approaches i find that the differences are largely due to the much higher variability of stock returns and its implied intertemporal substitution in marginal utility also contrary to conventional wisdom the differences in gains from the two approaches do not arise from treating stock returns as exogenous rather than endogenous

the effects of an increase in energy efficiency on the kenya economy abstract there are reasons to believe that improved energy efficiency still is an important energy development policy despite stable oil prices abundant oil supplies and end of the cold war the political reasons are uncertainty of the current gulf situation and prevalent wars in the former eastern bloc countries increasing concern over global environmental problems the existence of imperfect energy markets and the desire for rapid economic growth in developing countries are the other reasons this paper analyses the effects of energy management policies on the kenyan economy using a computable general equilibrium model simulations show that an increase in energy efficiency leads to reduced dependence on foreign energy sources promotion of reliable domestic energy sources promotion of conservation of all forms of energy saves scarce foreign currency and preserves the environment

optimal security design how should new securities be designed traditional theories have little to say on this the literature on capital structure and general equilibrium theories with incomplete markets take the securities firms issue as exogenous this paper explicitly incorporates the transaction costs of issuing securities and develops a model where the instruments that are traded are chosen optimally and the economy s market structure is endogenous among other things it is shown that the firm s income stream should be split so that in every state all payoffs are allocated to the security held by the group that values them most this abstract was borrowed from another version of this item

optimality of incomplete markets abstract in a static exchange economy where the traders initial endowments are risky the optimality of the financial structure is studied when markets are incomplete only financial structures with the same number of assets are compared a market structure is optimal when in a particular economy it yields an allocation of risks which cannot be pareto dominated through the implementation of any other market structure in a linear gaussian setup the optimal market structures are shown to span an eigenspace of a matrix which combines the risk exposures of the participants in the market approximately weighted by a measure of their risk aversions journal of economic literature classification numbers d60 g10

commission revenue maximization in a general equilibrium model of asset creation abstract a general equilibrium model of endogenous asset formation is given in which a monopolistic agent called the designer can create any types of assets and charage commissions as long as the total number of the types of assets does not exceed some given constant when the designer can create at most two assets a commission revenue maximizers always exists otherwise it may not moreover the so called maximizers may be badly behaved a profit maximiser may not exist even when the number of types of assets is endogenously determined from a positive fixed costs of creating an asset journal of economic literature classification numbers d52 d80

prospects for non opec oil supply abstract the political and economic importance which has been attached to the oil industry in recent decades relates to the rapid increase in the demand for oil over the period from 1950 1980 and to the dominant role played by the politically volatile middle east in its supply although global demand for oil has grown little over the last decade during which period the role of middle east supplies has fallen both relatively and absolutely contemporary conventional wisdom on the future of oil envisages the reestablishment of middle east supply dominance this paper will challenge the validity of this view in the context of a realistic evaluation of the longterm demand prospects for the commodity

optimal financial market integration and security design 1 we study 2 period pure exchange capital asset pricing model capm economies with incomplete financial markets and restricted participation we characterize the optimal financial market structure and efficient innovations consisting of both the introduction of new assets and the integration of segmented markets welfare gains from innovations are maximal when the endowments of affected agents are negatively correlated uncoordinated innovations lead to efficient market structures if all assets have identical participation structure or the markets being integrated trade identical assets however coordination failure in the introduction of new assets may result when assets have participation structures that overlap only partially

institutional markets financial marketing and financial innovation firms and institutions are monitored and controlled through a complex set of implicit and explicit contractual relations because of these agency theoretic relations institu tional behavior in financial markets is not a simple reflection of the preference structures of individuals institutional preferences give rise to a demand for new financial instru ments and innovations even when the returns on these instruments are spanned in the sense of complete pricing the innovations can be thought of as solving moral hazard problems an agency theoretic example serves to illustrate the demand supply and financial marketing of stripped securities in short institutions matter the past two decades have witnessed an explosion of financial innovations the changes are too varied and diffuse to permit an easy taxonomy but broadly they seem to fall into two classes first there are the new securities and their markets beginning with puts and calls we have moved on to euromarkets mortgage pass throughs and cmo s strips straps and swaps putable converti bles primes and scores and s p futures and all of the other instruments that inhibit the financial zoo second there are the dynamic trading strategies that make heavy use of the new instruments basket and program trading the asset pricing theories that now characterize different types of money management and the various incarnations of portfolio insurance have changed financial decision making as dramatically as the available array of instruments has changed along with these changes has come an enormous increase in the demand for the services of financial economists we are called upon not only to value the new instruments and the new strategies but to design them as well like engineers

more efficient household electricity use since 1973 the efficiency of most energy uses in homes has improved throughout the oecd 1 this means that to provide a given amount of energy service for example heating cooling locomotion or mechanical force less energy is required today than was needed in the past these improvements have been gained through the introduction of new appliances and for space heating and cooling new homes with more efficient building shells and the retrofitting of the existing building stock in this report we analyse some of the past changes in the efficiency of household appliance electricity use and discuss prospects for and barriers to further increases in the future

the expected utility of the doubling strategy it has been noted that a certain continuous time trading strategy termed the doubling strategy generates a positive net return on borrowed funds with probability one and within a finite period of time since the doubling strategy seems to represent a free lunch or arbitrage opportunity a variety of constraints to render it infeasible have been proposed in this paper we show that the doubling strategy generates infinite disutility for a large class of utility functions and we can think of no utility function for a risk averse agent which is a counterexample harrison and kreps 5 pointed out that a certain continuous time trading strategy in frictionless markets since termed the doubling strategy generates a positive net return on borrowed funds with probability one and within a finite period of time moreover the returns can be made arbitrarily large by increasing the initial amount borrowed thus the doubling strategy seems to represent a free lunch or arbitrage opportunity the theory of valuation of derivative assets also assumes continuous time trading in frictionless markets an assumption necessary to argue that the derivative asset can be perfectly hedged by the underlying asset and the risk free asset as in black and scholes 2 or equivalently that the returns on the derivative asset can be replicated by a self financing trading strategy see harrison and kreps 5 or harrision and pliska 6 in addition it must be assumed that the economy is free of arbitrage opportunities so that the continuously revised hedge portfolio earns the risk free rate or again equivalently that the value of the derivative asset is equal to the replicating strategy s initial portfolio consequently harrison kreps and others have viewed the existence of the doubling strategy and its apparent violation of the arbitrage free economy condition as a serious problem in contingent claims theory more generally the doubling strategy seems to suggest an inconsistency in standard sets of assumptions e g diffusion type asset prices frictionless continuous time markets and market efficiency when sufficiently complex trading strategies are permitted since the doubling strategy was introduced by harrison and kreps a number of constraints have been proposed to eliminate the doubling strategy without at the same time ruling out the other continuous time trading strategies essential to derivative asset pricing and continuous time portfolio theory bounds on portfolio positions kreps 9 a positive constraint on wealth dybvig 3 and margin requirements heath and jarrow 7 more generally dybvig and huang 4 show that a lower bound on wealth precludes other complex trading strategies

the significance of the market portfolio the market portfolio is in one sense the least important portfolio to provide to investors in an j agent one period stochastic endowment economy where preferences are quadratic a social welfare minded contract designer would never create a contract that would allow trading the market portfolio even the complete set of contracts all j 1 of them which achieve a first best solution never span the market portfolio these conclusions rely on the assumption that the contract designer has perfect information about agents utilities we also show that as the contract designer s information about agents utilities becomes more imperfect the optimal contracts approach contracts that weight individual endowments in proportion to elements of eigenvectors of the variance matrix of endowments then if there is a strong enough market component to endowments a portfolio approximating the market portfolio may be the most important portfolio

asset prices and consumption in a model of perpetual youth i construct a general equilibrium overlapping generations model with heterogeneous agents and obtain analytical solutions to asset prices consumption and asset demands individuals have constant absolute risk aversion and a constant probability of dying agents have three stages in their lives in the first stage agents are young and constrained from investing in stocks in the second stage they work and in the third they retire i analyze asset prices numerically and with comparative statics changing any exogenous parameter has large effects on asset prices when there are large demographic changes to the population constrained from investing in stocks

measurement of market integration and arbitrage we develop a measurement theory of market integration based on two notions of integrated markets first two markets cannot be perfectly integrated in any sense if one can construct two portfolios one from each market that have identical payoffs but different prices in that case the law of one price is violated across the markets second they cannot be integrated in a stronger sense if there are cross market arbitrage opportunities two measures of market integration are developed respectively reflecting these notions the smaller the measures the more closely integrated in the respective senses the markets among other things they are interpreted as measuring pricing discrepancy between markets article published by oxford university press on behalf of the society for financial studies in its journal the review of financial studies

energy use in the service sector an international perspective abstract this study presents the first international comparison of energy use and structure in the service sector of major oecd countries this sector includes offices hospitals schools stores and other buildings commonly referred to as commercial buildings the authors separate service sector energy use from other sectors examine differences in fuel mix energy intensity electricity use and conservation experience as well as fundamental differences in the extent and make up of the building stock and the climate most countries are seen to have reduced energy intensity since 1973 all have reduced the share of heating oil and increased the use of electricity both for space conditioning as well as for other building services the authors find that energy intensity in us commercial and institutional buildings is among the highest in the oecd while electricity intensities in norway canada the usa and sweden are well above those in other countries

global implications of self oriented national monetary rules author s obstfeld maurice rogoff kenneth abstract it is well known that if international linkages are relatively small the potential gains to international monetary policy coordination are typically quite limited but what if goods and financial markets are tightly linked is it then problematic if countries unilaterally design their institutions for monetary stabilization are the stabilization gains from having separate currencies largely squandered in the absence of effective international monetary coordination we argue that under plausible assumptions the answer is no unless risk aversion is very high lack of coordination in rule setting is a second order problem compared to the overall gains from monetary policy stabilization

information heterogeneity and market incompleteness information is market consistent if agents only use market prices to infer the underlying states of the economy this paper applies this concept to a stochastic growth model with incomplete markets and heterogeneous agents the economy with market consistent information can never replicate the full information equilibrium and there are substantial differences in impulse responses to aggregate productivity shocks these results are robust to the introduction of a noisy public signal and aggregate financial markets we argue that the principle of market consistent information should be applied to any model with incomplete markets

infinite horizon incomplete markets the model of general equilibrium with incomplete markets is a generalization of the arrow debreu model which provides a rich framework for studying problems of macroeconomics this paper shows how the model which has so far been restricted to economies with a finite horizon can be extended to the more natural setting of an open ended future thereby providing an extension of the finite horizon representative agent models of modern macroeconomics to economies with heterogeneous agents and incomplete markets there are two natural concepts of equilibrium over an infinite horizon which prevent agents from entering into ponzi schemes that is from indefinitely postponing the repayment of their debts the first is based on debt constraints which place bounds on debt at each date event the second is based on transversality conditions which limit the asymptotic rate of growth of debt the concept of an equilibrium with debt constraint is a natural concept of equilibrium for macroeconomic analysis however the concept of an equilibrium with transversality condition is more amenable to theoretical analysis since it permits the powerful techniques of arrow debreu theory to be carried over to the setting of incomplete markets in an economy in which agents are impatient expressed by the mackey continuity of their preference orderings and have a degree of impatience at each date event which is bounded below a concept defined in the paper we show that the equilibria of an economy with transversality condition coincide with the equilibria with debt constraints an equilibrium with transversality condition is shown to exist it follows that for each economy there is an explicit bound m such that an equilibrium with explicit debt constraint m exists in which the constraint is never binding this latter property ensuring that the debt constraint whose objective is to prevent ponzi schemes does not in itself introduce a new imperfection into the model over and above the incompleteness of the markets

strategic financial innovation in segmented markets rohit rahi obtained his ph d in economics from stanford university in 1993 he is a reader in finance and economics and a member of the financial markets group at the london school of economics his research interests are in the theory of financial markets in particular arbitrage in segmented markets security design and asset pricing with asymmetric information and in general equilibrium theory with incomplete markets he has published articles in the review of economic studies journal of economic theory and journal of business he served a nine year term on the editorial board of the review of economic studies jean pierre zigrand is a lecturer at the london school of economics his research interests are asset pricing financial intermediation theory and general equilibrium theory any opinions expressed here are those of the authors and not necessarily those of the fmg the research findings reported in this paper are the result of the independent research of the authors and do not necessarily reflect the views of the lse

improved energy efficiency in the industrialized countries past achievements co2 emission prospects abstract this paper explores the contribution which energy efficiency might make to future reductions in co 2 emissions trends in key energy use sectors and recent changes that may signal a slowdown in the rate of improvement of energy efficiency are examined the oecd countries reduced their energy use through greater efficiency by nearly 32 ej or 16 million bbl day oil equivalent between 1972 and 1985 but the pace of these improvements in energy use has begun to slow prospects for increased efficiency in each sector and the barriers to achieving those increases are discussed

economic integration and political disintegration in a world of trade restrictions large countries enjoy economic benefits because political boundaries determine the size of the market under free trade and global markets even relatively small cultural linguistic or ethnic groups can benefit from forming small homogeneous political jurisdictions this paper provides a formal model of the relationship between openness and the equilibrium number and size of countries and successfully tests two implications of the model firstly the economic benefits of country size are mediated by the degree of openness to trade secondly the history of nation state creations and secessions is influenced by the trade regime

welfare gains from international risksharing abstract this paper uses consumption data to compute yet unexploited welfare gains that can be achieved through risksharing among twenty oecd countries there is both aggregate national consumption risk and nondiversifiable individual specific risk countries engage in an optimal risksharing arrangement to pool risk associated with the aggregate consumption endowment streams welfare gains are associated with reduced consumption variability and with the international pricing of the consumption streams of individual countries the paper considers the standard vnm time additive preferences as well as nonexpected utility and habit formation preferences large unexploited gains are found under all sets of preferences leading to an international risksharing puzzle

anonymity and optimality of competitive equilibria when markets are incomplete abstract we study the optimality or efficiency of competitive equilibria in a standard two period economy where markets are incomplete statistical information about consumers preferences and endowments is known to a social planner but the planner cannot observe consumers types directly a competitive equilibrium is anonymous constrained optimal if the social planner cannot pareto improve upon the equilibrium allocation by intervening in asset markets with any asset trade rule satisfying anonymity in some cases a competitive equilibrium is robustly anonymous constrained optimal whereas it is known that competitive equilibria are generically constrained suboptimal for the case of completely observable types journal of economic literature classification numbers d52 d82 h21

financial integration and growth in a risky world abstract we revisit the debate on the benefits of financial integration in a two country neoclassical growth model with aggregate uncertainty the framework accounts simultaneously for gains from a more efficient capital allocation and gains from risk sharing together with their interaction global numerical methods allow for meaningful welfare comparisons gains from integration are quantitatively small even for riskier and capital scarce emerging economies these countries import capital for efficiency reasons before exporting it for self insurance leading to capital flows and growth reversals along the transition this opens the door to richer empirical implications than previously considered in the literature

speculation and risk sharing with new financial assets while the traditional view of nancial innovation emphasizes the risk sharing role of new nancial assets belief disagreements about these assets naturally lead to speculation which represents a powerful economic force in the opposite direction this paper investigates the eect of nancial innovation on portfolio risks in an economy when both the risk sharing and the speculation forces are present financial assets provide hedging services but they are also subject to speculation because traders do not necessarily agree about their payos i de ne the average variance of traders net worths as a measure of portfolio risks for this economy and i decompose it into two components the uninsurable variance de ned as the average variance that would obtain if there were no belief disagreements and the speculative variance de ned as the residual variance that results from speculative trades based on belief disagreements financial innovation always decreases the uninsurable variance because new assets increase the possibilities for risk sharing my main result shows that nancial innovation also always increases the speculative variance this is true even if traders completely agree about the payos of new assets the intuition behind this result is the hedge more bet more eect traders use new assets to hedge their bets on existing assets which in turn enables them to place larger bets and take on greater risks my second set of results concern endogenous nancial innovation when belief disagreements are su ciently large a pro t seeking market maker introduces assets that maximize the average variance among all possible choices completely disregarding the risk sharing motive for nancial innovation my third set of results concern a calibration of the model in the context of the gdp indexed assets proposed by athanasoulis and shiller 2001 when traders have reasonable amounts of belief disagreements these assets would have the unintended consequence of increasing their consumption risks

measuring asset values for cash settlement in derivative markets hedonic repeated measures indices and perpetual futures two proposals are made that may facilitate the creation of derivative market instruments such as futures contracts cash settled based on economic indices the first proposal concerns index number construction indices based on infrequent measurements of nonstandardized items may control for quality change by using a hedonic repeated measures method an index number construction method that follows individual assets or subjects through time and also takes account of measured quality variables the second proposal is to establish markets for perpetual claims on cash flows matching indices of dividends or rents such markets may help us to measure the prices of the assets generating these dividends or rents even when the underlying asset prices are difficult or impossible to observe directly a perpetual futures contract is proposed that would cash settle every day in terms of both the change in the futures price and the dividend or rent index for that day this paper concerns problems in the measurement of asset values or present values problems that if solved may facilitate the creation of new hedging vehicles new cash settled futures options and other derivative financial products the greatest components of world wealth are not hedgeable at all and

the cyclical behavior of individual production series 1889 1984 this paper uses simple summary statistics to analyze the volatility persistence and comovement of 38 annual individual production series for the period 1889 1984 it seeks to identify the size source and correlation of fluctuations in the production of specific commodities within various sample periods and to analyze possible changes in these characteristics over time the paper also discusses the implications of the behavior of individual production series for the behavior of the aggregate economy within the prewar interwar and postwar eras

litigation liability and incentives for care abstract in this paper potential injurers are subject to a negligence standard and differ in cost of taking care in the event of accident the injurer s degree of care is private information in litigation that follows award of damages for pain and suffering will lead to a general increase in care and hence reduce the likehood of accident a tighter negligence standard will lead some potential injurers to take more care and others to take less adoption of a rule under which the loser at trial must pay the litigation costs of the winner will reduce the pressure for punitive damages

design and marketing of financial products marketing costs are introduced into the security design environment outlined in allen and gale 1988 it is shown that splitting the firm s cash flow between products enhances their investor appeal and reduces marketing costs we also explain how the extremal product design in allen and gale is thereby avoided and how in simple cases debt equity or warrants can be optimal furthermore we illustrate in general terms how the optimal solution employs portfolios of option type products and we give an example of two optimal products that share profits in seven of eight states article published by oxford university press on behalf of the society for financial studies in its journal the review of financial studies

endogenous determination of the degree of market incompleteness in futures innovation abstract this paper studies the determination of the number of futures contracts created by an exchange we show that though the exchange can create the futures contracts costlessly if the investors have differential information there may be an upper bound on the number of contracts that the exchange is willing to create in a stylized economy we investigate what type of contracts and how many of these the exchange is willing to create journal of economic literature classification numbers d52 d82 g14

an evolutionary approach to financial innovation the purpose of this paper is to explain why some markets for financial products take off while others vanish as soon as they have emerged to this end we model an infinite sequence of capm economies in which financial products can be used for insurance purposes agents participation in these financial products however is restricted consecutive stage economies are linked by a mapping transition function which determines the next period s participation structure from the preceding period s participation the transition function generates a dynamic process of market participation which is driven by the percentage of informed traders and the rate at which a new asset is adopted we then analyse the evolutionary stability of stationary equilibria in accordance with the empirical literature on financial innovation it is obtained that the success of a financial innovation a mutation depends on a sufficiently high trading volume marketing and new and differentiated hedging opportunities in particular a set of complete markets forming a stationary equilibrium is robust with respect to any further financial innovation while this is not necessarily true for a set of incomplete markets

world income components measuring and exploiting risk sharing opportunities a method is constructedfor decomposing the variance of changes in incomes in the world into components to indicate the most important risk sharing opportunities among people of the world a constant absolute risk premium carp model an intertemporal general equilibrium model of the world is presented to permit optimal contract design for a contract designer maximizing a social welfare function the optimal contracts maximize the equilibrium world real interest rate securities are defined in terms of eigenvectors of a transformed variance matrix the method is applied using penn world table data on the g 7 countries 1950

destructive interference in an imperfectly competitive multi security market abstract a general equilibrium framework is employed to illustrate how the advent of trading in new securities about which an insider has private information might cause a collapse of prevailing security markets roughly securities that allow the insider to hedge his portfolio risk interfere with one other and in some cases so much so that these securities cannot simultaneously trade in any equilibrium

risk management instruments for debt driven conservation efforts the case of india s project tiger abstract project tiger has been india s premier case of conservation success since mid 1990s select project tiger reserves in india were chosen for intensive funding by the global environment facility the international development agency ida and the government of india under the india eco development project this project marked a modest shift towards debt based funding the gef project has become a benchmark for tiger conservation in india both in terms of management outcomes and scale and scope of funding however in the absence of large scale budgetary support or self generating income flows it becomes difficult for the gef type of project to be replicated in other tiger reserves of the country debt instruments hold promise as enablers of conservation finance the paper proposes issue of tiger bonds to meet the financial requirements of tiger reserves though attractive as a debt instrument a tiger bond could nevertheless entail interest rate and default risks bioprospecting activities form good revenue sources for tiger reserves to pay off their debts however bioprospecting activities do not provide assured returns to tiger reserves pharmaceutical companies that prospect for genetic resources and practice real options approach to r d investment planning adopt multi phased investment systems and sequential searches that gives them the flexibility to abandon r d projects from the point of view of genetic resource providing entities like project tiger reserves the postponement value generated by real options enables a drug company to tap substitutes for the genetic resources that form the subject matter of bioprospecting contracts to obviate possible repayment risks by tiger reserves the paper advocates the institution of put bonds as a risk management tool for project tiger reserves in order to hedge themselves against loan defaults arising from possible loss in bioprospecting income the paper also brings out the mechanics of the issue of tiger bonds in the indian context it is argued that a put bond not only hedges default risks but would also aid value discovery and payment for ecosystem services as far as the project tiger reserves of india are concerned

financial innovation the bright and the dark sides based on data from 32 countries over the period 1996 2010 this paper is the first to assess the relationship between financial innovation on the one hand and bank growth and fragility as well as economic growth on the other hand we find that different measures of financial innovation capturing both a broad concept and specific innovations are associated with faster bank growth but also higher bank fragility and worse bank performance during the recent crisis these effects are stronger in countries with larger securities markets and more restrictive regulatory frameworks in spite of these seemingly ambiguous findings our evidence points to a positive net effect of financial innovation on economic growth financial innovation is associated with higher growth in countries and industries with better growth opportunities

exchangeability and its economic applications abstract the symmetry possessed by exchangeability is the key to its usefulness the methods that are used to comprehend reality will edify insofar as they reflect this symmetry this is true of theoretical models empirical methods and algorithms indeed if the design of mechanisms is by rearrangement of natural matter their survival value will depend on the degree to which they retain the symmetry of the original matter this comment encompasses complex machinery and sophisticated political social and economic institutions the paper simply embroiders this observation

consumption puzzles and precautionary savings abstract when marginal utility is convex agents accumulate savings as a precautionary measure against labor income eventualities this paper shows that precautionary savings can go a long way in making the excess growth excess smoothness and excess sensitivity features of consumption consistent with the stochastic processes of labor income observed in the u s at the microeconomic level

dynamic asset pricing with non redundant forwards abstract in an incomplete market in which non redundant forward contracts contribute to span the uncertainty some standard results of portfolio theory must be amended when the investment opportunity set is driven by k state variables a k 3 mutual fund separation theorem is obtained in lieu of merton s k 2 fund separation result the additional fund is a portfolio that hedges the interest rate risk brought about by the optimal portfolio strategy itself second the mean variance efficiency of the market portfolio of cash assets is neither a necessary nor a sufficient condition for the linear relationship between expected return and beta to hold third the pricing equation for a forward contract is shown to contain an extra term relative to that for a cash asset term we name strategy risk premium

financial innovation and portfolio risks i illustrate the effect of financial innovation on portfolio risks by using an example with risk sharing needs and belief disagreements i consider two types of innovation product innovation formalized as an expansion of new financial assets and process innovation formalized as a reduction in transaction costs when belief disagreements are large both types of innovation increase portfolio risks moreover endogenous financial innovation is directed towards speculative assets that increase portfolio risks

social security and individual accounts as elements of overall risk sharing the widespread public and political impetus in the united states and elsewhere to revamp social security to incorporate some form of individual accounts creates a time of opportunity it is a time when people want to see the better exploitation of the available trade off between risk and return and a time to reconsider the foundations of the social security system so that it can much better serve its intended purpose as a manager of risks as i argue in my new book the new financial order risk in the 21st century shiller 2003 the time when we redesign social security ought to be a time when we carefully consider the fundamental intergenerational risk management problem and define choices in individual accounts that reflect the true problem it is also a time when we must make creative use of insights from behavioral economics that have emerged over the years finally it is a time for an expanded exploitation of our new electronic information technology we should not miss this opportunity this means we must work now toward solving a complex constrained optimization problem where the objective is to maximize a social welfare function involving all generations and the constraints reflect the varying degrees of individual optimization ability psychological underpinnings of human behavior and modem information technology

limits of arbitrage theory and evidence from the mortgage backed securities market limits of arbitrage theories hypothesize that the marginal investor in a particular asset market is a specialized arbitrageur rather than a diversified representative investor we examine the mortgage backed securities mbs market in this light we show that the risk of homeowner prepayment which is a wash in the aggregate is priced in the mbs market the covariance of prepayment risk with aggregate wealth implies the wrong sign to match the observed prices of prepayment risk the price of risk is better explained by a kernel based on mbs market wide specific risk consistent with the specialized arbitrageur hypothesis a number of recent limits of arbitrage theories predict that the distressed liquidation of assets by hedge funds results in a large drop in asset prices see for example shleifer and vishny 1997 kyle and xiong 2001 gromb and vayanos 2002 geanakoplos 2003 or he and krishnamurthy 2006 these theories are often referenced in explaining episodes of market illiquidity and falling asset prices such as the events during the fall of 1998 in traditional asset pricing theory the marginal investor in every asset market is the same broadly diversified representative investor thus a hedge fund liquidating 200 billion of mortgage backed securities finds a large pool of ready buyers comparable to the entire capital market and the liquidation does not affect expected returns because the representative investor acts quickly to eliminate excess returns according to the limits of arbitrage theory on the other hand the marginal investor in a particular asset market is an investor who specializes in that market in this case liquidations can have large effects on prices given that the relevant set of buyers is a smaller specialized pool of investors

optimal futures innovation in a dynamic economy the discrete time case abstract we study the optimal futures innovation in a dynamic economy and investigate how the results obtained in a static economy should be modified due to the possibility of dynamic trading we analyze three different notions of ex ante optimality depending on the authority s ability to redistribute wealth among the investors and characterize the optimal futures innovation in each sense journal of economic literature classification numbers d52 d60 g10

individual risk and mutual insurance this paper examines how in the presence of individual risk economic efficiency can be achieved without an unrealistically large number of contingent claims market uncertainty is specified in such a way that general types of individual risk and collective risk are properly accounted for and so that specifically market clearing is always satisfied ex post as well as ex ante we show that consistency of beliefs and optimality of allocation can be guaranteed with an appropriate array of pure arrow securities to spread collective risk and mutual insurance policies to pool individual risk when there is individual risk common to like groups of individuals pooling risk by means of mutual insurance permits substantial economizing on market transactions as compared to those required if dealing instead with the full complement of pure arrow securities we show that if there are n households consisting of h types each facing the possibility of being in s individual states together with t collective states then ensuring pareto optimality requires only h s 1 t independent mutual insurance policies plus t pure arrow securities our results also help to clarify the question of which missing markets may affect allocational efficiency

optimal incomplete markets with asymmetric information abstract this paper provides a simple parametric framework for comparing alternative incomplete asset structures in a productive economy focusing on the role of assets in allocating risk and transmitting private information it characterizes asset structures that are constrained efficient in the sense that no other asset structure with the same number of securities leads to a pareto dominating allocation in equilibrium specifically a constrained efficient asset structure must be efficient with respect to both risk sharing and information transmission explicit optimality criteria are developed and used to evaluate innovation by volume maximising futures exchanges journal of economic literature classification numbers g14 d52 d82

is food financialized yes but only when liquidity is abundant abstract in this paper we investigate whether commodity index trader cit positions help to explain the increase in the correlations between agricultural commodities and equities starting around 2008 some argue institutional investors who invest both in stock and commodity markets demolish the borders between these two seemingly unrelated markets and increase correlations a recent phenomenon known as financialization yet some others argue recently correlations have decreased back to historical levels and the increase between 2008 and 2012 was merely due to a business cycle effect our results do not support one side at the expense of the other but rather shows that both factors are important in explaining the correlations between agricultural commodities and stocks furthermore we find that cits prefer to go back to their circle of competence under scarce liquidity and thus correlations decrease back to levels absent institutions hence low liquidity is a significant obstacle inhibiting financialization to occur

the role of liquidity in futures market innovations i characterize the optimal design of a new futures market an innovation by an exchange in the presence of market frictions futures markets am characterized by both the contract and the level of trader participation both can be determined by an exchange a game in which exchanges simultaneously design markets is c onsidered and a particular equilibrium not necessarily unique is constructed a game in which exchanges sequentially design markets and incur design costs is also considered and the generically unique equilibrium is constructed the nature of equilibrium with multiple exchanges is discussed in these simultaneous and sequential settings illustrating the role played by liquidity considerations both in market design and in the nature of competition between exchanges

credible pretrial negotiation pretrial negotiation is a structured environment in which to study bargaining with incomplete information when a plaintiff believes that a defendant owes him damages he may first attempt to reach a private settlement before resorting to a costly court imposed judgment a central issue in their negotiations is whether the plaintiff s threat to litigate is credible it is possible for the plaintiff to undermine the credibility of his litigation threat by making a settlement demand that is insufficient as a result the plaintiff must raise his settlement demand to limit the amount of bad news he can learn if his offer is rejected when this credibility constraint is binding traditional comparative static results are reversed in addition even though the defendant is being sued he wants the plaintiff s threat to be credible

financially constrained lawyers an economic theory of legal disputes abstract financial constraints reduce the lawyer s ability to file lawsuits and bring cases to trial as a result access to justice for victims pretrial bargaining and potential injurers precaution might be affected we study civil litigation using a model that allows for asymmetric information financially constrained lawyers third party lawyer lending and a continuum of plaintiff s types we contribute to the economic analysis of law by generalizing seminal models of litigation bebchuk 1984 bebchuk 1988 katz 1990 offering the first formal definition of access to justice and presenting comprehensive social welfare analysis of relevant public policy we provide complete equilibrium characterization and identify necessary conditions for the existence of the mixed and pure strategy pbe access to justice is denied to some victims under the mixed strategy equilibrium we then study the social welfare effects of policies aimed at relaxing lawyers financial constraints and identify a necessary and sufficient condition for a welfare enhancing effect

some results in the capm with nontraded endowments the paper establishes a positive security market line in the capm with nontraded endowments the effects of a market structure change on the security market line are analyzed when the equilibrium allocation is affected by the change

collateral motivated financial innovation collateral frictions have a profound effect on our economic landscape ranging from the design of financial securities laws and institutions to various rules and regulations we analyze a model with disagreement where securities and collateral requirements are endogenous it shows that the security that isolates the variable with disagreement is optimal in the sense that alternative securities cannot generate any trading in an economy with n states investors may introduce more than n securities and markets are still incomplete the model has several novel predictions on the behavior of basis the spread between the prices of an asset and its replicating portfolio

the effect of third party funding of plaintiffs on settlement a significant policy concern about the emerging plaintiff legal funding industry is that loans will undermine settlement when the plaintiff has private information about damages we find that the optimal plaintiff funder loan induces all plaintiff types to make the same demand resulting in full settlement implementation may entail a very high repayment amount plaintiffs attorneys with contingent fee compensation benefit from such financing as it eliminates trial costs when the defendant has private information about his likelihood of being found liable we find that the likelihood of settlement is unaffected in both settings the defendant s incentive for care taking is unaffected jel d82 k41 l84 since the late twentieth century the financing of lawsuits wherein third parties provide direct financial support to tort plaintiffs has developed into an emerging industry in the united states and worldwide 1 with a potentially substantial effect on the efficiency of the legal system such financial support takes the form of a nonrecourse loan that is the litigation funder advances payment to the plaintiff and repayment occurs only if the plaintiff is successful either in settlement or at trial and then only up to the plaintiff s recovery net of attorney fees which are generally a percentage of the plaintiff s received transfer from the defendant focusing on the nonrecourse aspect some courts and commentators have bemoaned such loans arguing that they will necessarily lead to increased failure of settlement negotiations and interference in the attorney client relationship 2 in this paper we use a signaling model to analyze the effect of such third party loans to plaintiffs on settlement bargaining when a plaintiff has private information 1 for discussions of litigation funding outside the united states see hodges vogenauer and tulibacka 2010 chen 2012 and abrams and chen 2013

optimal design of securities under asymmetric information a firm must decide what security to sell to raise external capital to finance a profitable investment opportunity there is ex ante asymmetry of information regarding the probability distribution of cash flow generated by the investment in this setting we derive necessary and sufficient conditions for a security to be optimal uniquely optimal that is for pooling at this security to be an the unique equilibrium outcome using these conditions we show that the debt contract is uniquely optimal if and only if cash flows are ordered by strict conditional stochastic dominance finally we derive an equivalence relationship between optimal security designs and designs that minimize mispricing