Information Revelation and Market Incompleteness

Abstract:     
This paper introduces a theory of market incompleteness based on the information transmission role of prices and its adverse impact on the provision of insurance in financial markets. We analyse a simple security design model in which the number and payoff of securities are endogenous. Agents have rational expectations and differ in information, endowments, and attitudes toward risk. When markets are incomplete, equilibrium prices are typically partially revealing, while full relevation is attained with complete markets. The optimality of complete or incomplete markets depends on whether the adverse selection effect (the unwillingness of agents to trade risks when they are informationally disadvantaged) is stronger or weaker than the Hirshleifer effect (the impossibility of trading risks that have already been resolved), as new securities are issued and prices reveal more information. When the Hirshleifer effect dominates, an incomplete set of securities is preferred by all agents, and generates a higher volume of trade.

Keywords: Information Revelation, Rational Expectations, Complete Markets, Adverse Selection, Hirshleifer Effect

JEL Classification: D11, D50, D61, D82, D84, G12, G14

Accepted Paper Series