We propose a dynamic theory of financial intermediaries that are better able to collateralize claims than households, that is, have a collateralization advantage. Intermediaries require capital as they have to finance the additional amount that they can lend out of their own net worth. The net worth of financial intermediaries and the corporate sector are both state variables affecting the spread between intermediated and direct finance and the dynamics of real economic activity, such as investment, and financing. The accumulation of net worth of intermediaries is slow relative to that of the corporate sector. The model is consistent with key stylized facts about macroeconomic downturns associated with a credit crunch, namely, their severity, their protractedness, and the fact that the severity of the credit crunch itself affects the severity and persistence of downturns. The model captures the tentative and halting nature of recoveries from crises.

We develop a dynamic model of investment, capital structure, leasing, and risk management based on firms' need to collateralize promises to pay with tangible assets. Both financing and risk management involve promises to pay subject to collateral constraints. Leasing is strongly collateralized costly financing and permits greater leverage. More constrained firms hedge less and lease more, both cross-sectionally and dynamically. Mature firms suffering adverse cash flow shocks may cut risk management and sell and lease back assets. Persistence of productivity reduces the benefits to hedging low cash flows and can lead firms not to hedge at all.

In a one-period model of market making with many exogenously informed traders, we first show that the variance of prices and expected trading volume depend on the public information released at the start of trading. This is accomplished by representing beliefs with elliptically contoured distributions, for which the form of optimal decision rules does not depend on the specific distribution used. Second, if the model is altered so that the decision to become informed is made endogenous, then the decision rules of the market-maker and informed traders depend on the public information. Third, in a multiperiod model with many informed traders and long-lived private information, recursion formulas similar to those of Kyle (1985) hold for all elliptically contoured distributions, trading volume is autocorrelated and, unless per period liquidity trading is bounded away from zero as new trading periods are added, informed traders’ profits vanish.

In an adverse selection model of a securities market with one informed trader and several liquidity traders, we study the implications of the assumption that the informed trader has more information on Monday than on other days. We examine the interday variations in volume, variance, and adverse selection costs, and find that on monday the trading costs and the variance of price changes are highest, and the volume is lower than on Tuesday. These effects are stronger for firms with better public reporting and for firms with more discretionary liquidity trading.

The practices of preferencing and internalization have been alleged to support collusion, cause worse execution, and lead to wider spreads in dealership style markets relative to auction style markets. For a sample of London Stock Exchange stocks, we find that preferenced trades pay higher spreads, however they do not generate higher dealer profits. Internalized trades pay lower, not higher, spreads. We do not find a relation between the extent of preferencing or internalization and spreads across stocks. These results do not lend support to the “collusion” hypothesis but are consistent with a “costly search and trading relationships” hypothesis.

Using London Stock Exchange data, we test the central implication of the canonical model of Ho and Stoll (1983) that relative inventory differences determine dealer behavior. We find that relative inventories explain which dealers obtain large trades and show that movements between best ask, best bid, and straddle are highly correlated with both standardized and relative inventory changes. We show that the mean reversion in inventories is highly nonlinear and increasing in inventory levels. We show that a key determinant of variations in interdealer trading is inventories and that interdealer trading plays an important role in managing large inventory positions.

This paper uses a nonlinear arbitrage-pricing model, a conditional linear model, and an unconditional linear model to price international equities, bonds, and forward currency contracts. Unlike linear models, the nonlinear arbitrage-pricing model requires no restrictions on the payoff space, allowing it to price payoffs of options, forward contracts, and other derivative securities. Only the nonlinear arbitrage-pricing model does an adequate job of explaining the time-series behavior of a cross section of international returns.

Both financing and risk management involve promises to pay that need to be collateralized, resulting in a financing versus risk management trade-off. We study this trade-off in a dynamic model of commodity price risk management and show that risk management is limited and that more financially constrained firms hedge less or not at all. We show that these predictions are consistent with the evidence using panel data for fuel price risk management by airlines. More constrained airlines hedge less both in the cross section and within airlines over time. Risk management drops substantially as airlines approach distress and recovers only slowly after airlines enter distress.

The term “illegal price manipulation ” is diffi-cult to define. Current U.S. law does not explic-itly define it. The finance and economics litera-ture uses the term “manipulation ” in an impre-cise manner. This paper proposes that a trading strategy not be classified as “illegal price manip-ulation ” unless the violator’s intent is to pursue a scheme that undermines economic efficiency both by making prices less accurate as signals for efficient resource allocation and by making mar-kets less liquid for risk transfer. Since price ef-fects are market-wide, we treat the terms “price manipulation ” and “market manipulation ” as synonyms. Our definition applies equally to fi-nancial and commodities markets.

ABSTRACT Collateral constraints imply that financing and risk management are fundamentally linked. The opportunity cost of engaging in risk management and conserving debt capacity to hedge future financing needs is forgone current investment, and is higher for more productive and less well‐capitalized firms. More constrained firms engage in less risk management and may exhaust their debt capacity and abstain from risk management, consistent with empirical evidence and in contrast to received theory. When cash flows are low, such firms may be unable to seize investment opportunities and be forced to downsize. Consequently, capital may be less productively deployed in downturns.