Financial Expertise as an Arms Race
University of Pennsylvania - The Wharton School
Richard C. Green
Carnegie Mellon University - David A. Tepper School of Business
University of Texas-Austin
July 6, 2011
Journal of Finance, 2012
We show that firms intermediating trade have incentives to overinvest in financial expertise, and that these investments can be destabilizing. Financial expertise in our model improves firms' ability to accurately estimate value when trading a security. It creates adverse selection, which under normal circumstances works to the advantage of the expert. It deters opportunistic bargaining by counterparties. That advantage is neutralized in equilibrium, however, by offsetting investments competitors make. Moreover, when volatility rises the adverse selection created by expertise triggers breakdowns in liquidity, destroying gains to trade and thus the benefits that firms hope to gain through high levels of expertise.
Number of Pages in PDF File: 50
JEL Classification: G20, D82, C78Accepted Paper Series
Date posted: August 30, 2009 ; Last revised: March 15, 2013
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