Market Based, Segregated Exchanges with Default Risk

Kilenthong, Weerachart and Townsend, Robert (2007): Market Based, Segregated Exchanges with Default Risk.

Abstract

This paper studies a competitive general equilibrium model with default and endogenous collateral constraints. Even though all collateralized contracts are allowed, the possibility and desirability of trade in spot markets (or the equivalent trade in ex ante asset backed securities) creates externalities, as spot prices (or security prices) and the bindingness of collateral constraints interact. We show that if agents are allowed to contract ex ante on market fundamentals determining the state-contingent spot price, over and above contracting on true underlying states of the world, then competitive equilibria with bundled securities and commodities and with endogenous collateral constraints are equivalent with Pareto optima. Examples show that it is possible to have multiple market fundamentals in equilibrium. Equivalently, it is possible for there to be segregation into distinct competitive securities exchanges with endogenous (positive and negative) entry fees. Fees accrue to borrowers who are otherwise collateral constrained.

• Item Type: MPRA Paper
• Language: English
• Keywords: default; endogenous collateral; externalities; segregated exchanges; Walrasian equilibrium; limited commitment; financial crises
• Subjects: D - Microeconomics > D5 - General Equilibrium and Disequilibrium > D53 - Financial Markets; D - Microeconomics > D6 - Welfare Economics > D62 - Externalities; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy; D - Microeconomics > D5 - General Equilibrium and Disequilibrium > D52 - Incomplete Markets; E - Macroeconomics and Monetary Economics > E2 - Consumption, Saving, Production, Investment, Labor Markets, and Informal Economy > E20 - General; G - Financial Economics > G0 - General > G01 - Financial Crises

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