Heterogeneity in financial markets
Creators: name: Rubin, Amir
Publisher: name: University of British Columbia
Year: 2009

description: The thesis studies different forms of heterogeneity and their effect on financial markets. The first chapter deals with a conflict that is typically neglected in the corporate finance literature. Shareholders want to maximize their portfolio value and not any specific firm value. These two objectives are quite different if firms affect the cashflow of other firms in the market. We show that undiversified corporate managers who are compensated according to firm value tend to pursue projects that increase firm value but not necessarily portfolio value. This conflict can be reduced by issuing debt, and can be reduced even more with option grants. Both contracts create a risk-shifting effect, which offsets the incentive of the manager to engage in some safe projects that do not enhance the opportunity set. We show that promoting risk-shifting while incurring some under-investment, induces managers to take on comparatively more opportunity set enhancing projects, which in turn increase the shareholder's portfolio value. The second chapter deals with a welfare comparison between the competitive limit order book structure and the monopolist market maker structure. The comparison is done in an economy where market volume increases liquidity. We show that in a symmetric information economy, where investors differ only in their initial endowments, a market maker can solve a free-rider problem that exists in the competitive limit order book market. Since individual investors assume that their own trade has no effect on market liquidity, they disregard it when maximizing their expected utility. A monopolist market maker that provides a pricing schedule to the market and exerts search and promotion costs to increase trading volume can solve the free-rider problem. The market maker facilitates all trade in the economy and guarantees a reduction in liquidity risk. Under some circumstances, the benefits of solving the free-rider problem outweigh the costs of having a market maker who collects a fee. When allowing for competition, we have a free-rider problem from the market makers perspective. As more market makers compete in the market, each market maker can commit to relatively lower total volume, which results in a double free-rider problem. Thus, while a monopolist market maker can endogenize the volume decision completely, a competitive structure cannot. Finally, the third chapter deals with the removal of short sale constraints when investors have different beliefs about the final payoff distribution of a security. Our focus is the effect on the price volatility of the underlying asset. The intuition is derived from simple geometry. We show that the price curve as a function of the uncertain future payoff changes when investors are able to act on the belief that the price of the share is relatively high. In a very simple model with successive generations of single-period investors, we show that volatility can either increase or decrease, depending on the variability of news about final payoffs. As an empirical illustration, we consider data from the Israeli stock market. The data show that volatility increased following the initiation of index options, consistent with the fact that short sales were prohibited in Israel when index options were introduced.