Optimal Financial Integration and Security Design

Abstract

We study two-period pure-exchange Capital Asset Pricing Model (CAPM) economies with a given degree of incompleteness of financial markets and given degrees of restricted participation of agents in the markets.

We characterize the optimal financial asset structure and the optimal composition of traders for such economies. We identify a minimal property of the optimal financial structures which is required to 'decentralize' such structures by means of financial innovations that (i) introduce new financial assets, and/or (ii) integrate segmented markets. We give a precise characterization of the conditions under which such a property is satisfied. We find that when the nature of restricted participation in markets for trading in different assets is different, the optimal financial structure is, in general, not 'decentralizable,' and the order in which innovating intermediaries introduce the financial assets affects the optimality of financial structures.

Keywords: security design, financial integration, incomplete markets, restricted participation, CAPM

JEL Classification: D58, D52, G12