Knowledge that Transforms

This paper analyzes the role of financial intermediaries as marketmakers in the market for interest rate swaps. We argue that intermediaries which hold large nontraded portfolios of swaps are efficient alternatives to direct hedging by counterparties in publicly traded cash and futures instruments. The efficiency afforded by the swap marketmaker derives from reduction in transactions costs, diversification of basis risk, and reduced agency costs of debt. The analysis provides an explanation for the existence and success of the swaps market as a means for spreading risk and for its dominance by large financial institutions.

The traditional structure-conduct-performance (SCP) hypothesis relates concentration and the mean level of prices but ignores the dispersion of prices around their mean levels. This paper tests two hypotheses which are capable of explaining both the mean and the dispersion of elements in the pricing vector of retail banks—a concentration/collusion-based hypothesis and an asymmetric information-based hypothesis. Evidence is found that the dispersion of bank fees across banks may be due to both market structure and information reasons. The level of bank fees appears to be generally insignificantly related to concentration.

We frequently observe that contracts do not include all of the contingencies that would seem to be necessary for optimal risk sharing between the parties to the contract. One reason may be that the possibility of renegotiation makes the contract more contingent than it appears. A simple contracting problem is used to show how even a simple contract may achieve optimal risk sharing if new information arrives slowly relatively to the speed of renegotiation.

This paper examines whether middle age American households purchase adequate amounts of life insurance. The analysis is based on SRI International's 1980, 1982, and 1984 surveys of the financial positions of American households. Our findings indicate that a significant minority of American wives are highly underinsured with respect to the possible deaths of their husbands. We find that 25 to 30% of wives are inadequately insured, by which we mean that they would suffer a loss in their rate of sustainable consumption of at least 30% in the event of being widowed. These findings on inadequate life insurance are even more striking if one focuses on those households in which over half of the couple's present expected value of resources is dependent on the husband's survival. The results of this paper together with those of the related literature strongly suggest that raising the share of social security benefits that are paid to surviving spouses as well as increasing employer-provided group life insurance could have a very considerable impact on the alleviation of poverty among widows, especially elderly widows.

This paper uses firm-level panel data to investigate the proposition that reliquification is an important phase of the business cycle. It occurs late during recessions and is characterized by prolonged reductions in real investment, caused by firms needing to accumulate assets in order to improve their financial health. The paper concludes that a buildup of assets precedes an increase in investment. This effect is more important for firms without access to organized bond markets and during recession years.

We consider a model in which the market period is divided into T rounds of trading, with the arrival of consumers determined exogenously. A monopolistic market maker sets the bid-price and the ask-price in each round, accepting all trades at the stated prices. Optimal prices remain constant when the aggregate supply and demand are known to the market maker, even if supplies and demands within individual rounds are not known. Examples illustrate the endogenous determination of inventory holding costs. The viability of a market-maker system is compared to an auction market with and without a “sophisticated” trader.

When information is sold, there is often a reliability problem since anyone can claim to have superior knowledge. Optimal strategies which allow a seller to establish that he is informed are considered in a standard one-period, two-asset model. When risk aversion is unobservable, an information market is viable and both the seller and the buyers are better off participating. However, the seller cannot obtain the full value of his information because of the reliability problem. This provides an opportunity for intermediation since an intermediary may be able to capture some of the remaining value.

This paper addresses the First Theorem of Welfare Economics in a moral hazard environment. An entrepreneur sells equity in a firm which he supplies with an unobservable, costly input. How much equity he retains determines his incentives and is observed by investors. The investors have rational expectaions which cause the equity price to increase in the amount of equity the entrepreneur retains. This gives the entrepreneur an incentive to retain equity and hence supply input. The entrepreneur may also be bound by an explicit incentive contract. In this framework, not all competitive equilibria are efficient, as defined relative to the moral hazard constraint. However, equilibria can be inefficient only if the entrepreneur's optimal input is nonunique or exhibits positive income effects.

We examine delivery systems that disseminate market timing information either through newsletters or by setting up timing funds in which investors can invest. Absent market imperfections, both systems produce the same result. With restrictions on borrowing, or with other nonlinearities, the newletter system is superior. This result does not depend on the cost of obtaining information or uncertainty about, or the manipulation of, the quality of the information. Institutional restrictions on borrowing, and preferences that lead to nonlinear responses to information signals, provide one explanation for the plethora of market timing newsletters and the paucity of market timing funds.

This paper considers a securities market in which orders are channeled through professional broker-dealers such as London's market makers or the large banks operating on continental exchanges. If these dual-capacity dealers can judge the motives behind their customers' orders, they can trade profitably on their own account (even if they cannot “front run,” that is, trade on their own account before executing a customer order). It is shown that the dealers have an incentive to satisfy roughly half of their customers' orders from their own inventory if they are sure that orders are liquidity-motivated and not based on inside information. As a result of dual-capacity dealing, transaction costs for liquidity-motivated traders in the aggregate fall, but they rise for those traders who are unable to convince any dealer that they have no inside information. The liquidity of the main market worsens, even though its effective liquidity for customers whose orders are partly filled from broker-dealer inventories improves.