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Mixed Signals: Investment Distortions with Adverse Selection

Matthew Darst and Ehraz Refayet ()
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No 2019-044, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

Abstract: We study how adverse selection distorts equilibrium investment allocations in a Walrasian credit market with two-sided heterogeneity. Representative investor and partial equilibrium economies are special cases where investment allocations are distorted above perfect information allocations. By contrast, the general setting features a pecuniary externality that leads to trade and investment allocations below perfect information levels. The degree of heterogeneity between informed agents' type governs the direction of the distortion. Moreover, contracts that complete markets dampen the impact of pecuniary externalities and change equilibrium distortions. Implications for empirical design in credit market studies and financial stability are discussed.

Keywords: Asymmetric Information; Cost Of Capital; Credit Default Swaps; Investment; Pecuniary Externality; Signalling (search for similar items in EconPapers)
JEL-codes: D52 D53 D82 E44 G32 (search for similar items in EconPapers)
Pages: 46
Date: 2019-06-21
New Economics Papers: this item is included in nep-cfn, nep-cta, nep-mac and nep-mic
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DOI: 10.17016/FEDS.2019.044

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