Size-discovery mechanisms allow large quantities of an asset to be exchanged at a price that does not respond to price pressure. Primary examples include “workup” in Treasury markets, “matching sessions” in corporate bond and CDS markets, and block-trading “dark pools” in equity markets. By freezing the execution price and giving up on market-clearing, size-discovery mechanisms overcome concerns by large investors over their price impacts. Price-discovery mechanisms clear the market, but cause investors to internalize their price impacts, inducing costly delays in the reduction of position imbalances. We show how augmenting a price-discovery mechanism with a size-discovery mechanism improves allocative efficiency.

We consider the problem of the design and sale of a security backed by specified assets. Given access to higher-return investments, the issuer has an incentive to raise capital by securitizing part of these assets. At the time the security is issued, the issuer's or underwriter's private information regarding the payoff of the security may cause illiquidity, in the form of a downward-sloping demand curve for the security. The severity of this illiquidity depends upon the sensitivity of the value of the issued security to the issuer's private information. Thus, the security-design problem involves a tradeoff between the retention cost of holding cash flows not included in the security design, and the liquidity cost of including the cash flows and making the security design more sensitive to the issuer's private information. We characterize the optimal security design in several cases. We also demonstrate circumstances under which standard debt is optimal and show that the riskiness of the debt is increasing in the issuer's retention costs for assets.

This article explores the information effect of financial risk management. Financial hedging improves the informativeness of corporate earnings as a signal of management ability and project quality by eliminating extraneous noise. Managerial and shareholder incentives regarding information transmission may differ, however, leading to conflicts regarding an optimal hedging policy. We show that these incentives depend on the accounting information made available by the firm. Under some circumstances, if hedge transactions are not disclosed (i.e., firms report only aggregate earnings), managers hedge to achieve greater risk reduction than they would if full disclosure were required. In these cases, it is optimal for shareholders to request only aggregate accounting reports.

This article presents convenient reduced-form models of the valuation of contingent claims subject to default risk, focusing on applications to the term structure of interest rates for corporate or sovereign bonds. Examples include the valuation of a credit-spread option.

This paper provides a simulated moments estimator (SME) of the parameters of dynamic models in which the state vector follows a time-homogeneous Markov process. Conditions are provided for both weak and strong consistency as well as asymptotic normality. Various tradeoff's among the regularity conditions underlying the large sample properties of the SME are discussed in the context of an asset pricing model.

A two-period (0 and T) Arrow^Debreu economy is set up with a general model of uncertainty.We suppose that an equilibrium exists for this economy.The Arrow-Debreu economy is placed in a Radner [31] setting; agents may trade claims continuously during [0,T].Under appropriate conditions it is possible to implement the original Arrow-Debreu equilibrium, which may have an infinite dimensional commodity space, in a Radner economy which has only a finite number of securities.This is done by opening the "right" set of securities markets, a set which effectively completes markets for the continuous trading Radner economy.

The probability of extreme default losses on portfolios of U.S. corporate debt is much greater than would be estimated under the standard assumption that default correlation arises only from exposure to observable risk factors. At the high confidence levels at which bank loan portfolio and collateralized debt obligation (CDO) default losses are typically measured for economic capital and rating purposes, conventionally based loss estimates are downward biased by a full order of magnitude on test portfolios. Our estimates are based on U.S. public nonfinancial firms between 1979 and 2004. We find strong evidence for the presence of common latent factors, even when controlling for observable factors that provide the most accurate available model of firm-by-firm default probabilities.

ABSTRACT This article presents a model for valuing claims subject to default by both contracting parties, such as swaps and forwards. With counterparties of different default risk, the promised cash flows of a swap are discounted by a switching discount rate that, at any given state and time, is equal to the discount rate of the counterparty for whom the swap is currently out of the money (that is, a liability). The impact of credit‐risk asymmetry and of netting is presented through both theory and numerical examples, which include interest rate and currency swaps.

This paper shows how the intraday allocation and pricing of overnight loans of federal funds reflect the decentralized interbank market in which these loans are traded. A would-be bor-rower or lender typically finds a counterparty institution by direct bilateral contact. Once in contact, the two counterparties to a potential trade negotiate terms that reflect their incentives for borrowing or lending, as well as the attrac-tiveness of their respective options to forego a trade and to continue “shopping around. ” This over-the-counter (OTC) pricing and allocation mechanism is quite distinct from that of most centralized markets, such as an electronic limit order book market in which every order is anony-mously exposed to every other order with a cen-tralized order-crossing algorithm. While there is a significant body of research on the microstructure of specialist and limit order book markets, most OTC markets do not have comprehensive transaction-level data available for analysis. The federal funds mar-ket is a rare exception. We go beyond a previ-ous study of the microstructure of the federal funds market (Craig H. Furfine 1999) by model-ing how the likelihood of matching a particular borrower with a particular lender, as well as the interest rate that they negotiate, depend on their respective incentives to add or reduce balances and their ability to conduct further trading with other counterparties (proxied by the level of their past trading volumes). Our results are consistent with the thrust of search-based OTC financial