Mixed Signals: Investment Distortions with Adverse Selection

46 Pages Posted: 17 Jul 2019

See all articles by Matthew Darst

Matthew Darst

Board of Governors of the Federal Reserve System

Ehraz Refayet

Office of the Comptroller of the Currency, Department of Treasury

Date Written: 2019-06-21

Abstract

We study how adverse selection distorts equilibrium investment allocations in a Walrasian credit market with two-sided heterogeneity. Representative investor and partial equilibrium economies are special cases where investment allocations are distorted above perfect information allocations. By contrast, the general setting features a pecuniary externality that leads to trade and investment allocations below perfect information levels. The degree of heterogeneity between informed agents' type governs the direction of the distortion. Moreover, contracts that complete markets dampen the impact of pecuniary externalities and change equilibrium distortions. Implications for empirical design in credit market studies and financial stability are discussed.

Keywords: Asymmetric Information, Cost Of Capital, Credit Default Swaps, Investment, Pecuniary Externality, Signalling

JEL Classification: D82, E44, G32, D52, D53

Suggested Citation

Darst, Matthew and Refayet, Ehraz, Mixed Signals: Investment Distortions with Adverse Selection (2019-06-21). FEDS Working Paper No. 2019-44. Available at SSRN: https://ssrn.com/abstract=3417741 or http://dx.doi.org/10.17016/FEDS.2019.044

Matthew Darst (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Ehraz Refayet

Office of the Comptroller of the Currency, Department of Treasury ( email )

400 7th Street SW
Washington, DC 20219
United States

HOME PAGE: http://www.occ.treas.gov/topics/economics/economics-staff/bios/ehraz-refayet-bio.html

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