Diversification and Screening
FEUNL Working Paper Series No. 610
48 Pages Posted: 27 Jan 2017
Date Written: October 2016
I study two-way effects between financial markets and contractual agreements with a risk sharing component, such as compensation packages within a firm, or mortgages and loans. I construct a model with many Units, in each of which one of the contracting individuals, the Agent, has private information, while the uninformed individual, the Principal, has the opportunity to trade with the Principals in other Units. I give general conditions under which financial markets induce a transfer of risk from Agents to Principals. I also show how asymmetric information interacts with financial markets through two channels. First, the distortion of the allocation of the high risk Agents, feeds back in the market portfolio increasing risk on markets, and in the contracts of the low risk Agents. Secondly, markets change the Principals' screening problem preventing low risk Agents from enjoying an information rent. The model results can explain empirical evidence from the subprime mortgage market during the securitization boom leading to the 2008 financial crisis and suggest further implications for other markets segment.
Suggested Citation: Suggested Citation