Essays in asset pricing with market imperfections

Buffa, Andrea (2012) Essays in asset pricing with market imperfections. Doctoral thesis, University of London: London Business School.

Abstract

This thesis is structured around two main chapters, which analyze the impact of market imperfections on financial markets in the presence of strategic behavior. An economic relevant friction I concentrate my research on regards default externalities and systemic risk. In particular, I study the strategic risk taking of highly-levered financial institutions within a structural model of credit risk, where I consider a context in which systemic default induces externalities that amplify the cost of financial distress. This represents a source of strategic interaction and mandates an analysis of financial institutions' asset allocations in coalescence. I derive a unique strategic equilibrium in which two heterogenous institutions adopt polarized and stochastic risk exposures, without sacrificing full diversification. In the presence of systemic externalities, both financial firms are concerned with maintaining sucient wealth in adverse states. To this purpose, the conservative institution reduces its risk exposure, whereas the aggressive institution optimally gambles on positive and negative outcomes by taking long and short positions in risky securities over time. This equilibrium mechanism increases the likelihood of a systemic crisis. In the second part of the thesis I explore the role of disclosure regulation in the presence of asymmetric information, as an institutional way to improve the efficiency and liquidity of the market. Is a more transparent market also more efficient and liquid? I address this question by analyzing the impact of mandatory ex-post disclosure of corporate insider trades (as in Section 16(a) of the U.S. Securities Exchange Act) in a dynamic model of strategic risk averse insider trading. I show that trade disclosure reduces informational efficiency of prices, may cause the market to be less liquid, and may increase insider's expected utility. In my model, the informed trader uses a less aggressive trading strategy in a more transparent market (i.e. with trade disclosure) in order to prevent the market maker from inferring perfectly the private information from public records, and to maintain her informational advantage over time. My result then questions the effectiveness of such securities regulation.