Optimal Financial Integration and Security Design

Abstract

We study two-period pure-exchange Capital Asset Pricing Model (CAPM) economies, for given degrees of incompleteness of financial markets and given degrees of restricted participation of agents in the markets. We characterize the optimal financial market structure of this economy, as well as efficient financial innovations consisting of both the introduction of new assets and the integration of segmented markets. We show that the optimal financial market structures maximize a simple criterion that captures the dispersion of the 'betas' of the participating agents. Our results imply that, in contrast with the prescription of the Optimal Currency Area literature, maximal advantage from the integration of financial markets arises for those economic regions whose endowment processes are minimally or negatively correlated. Moreover, we show that some coordination of the innovation process, e.g., in the form of consolidation of exchanges, is likely to be desirable when the integrating economies have segmented asset markets.

Keywords: Security design, financial integration, decentralizability, incomplete markets, restricted participation, CAPM

JEL Classification: D52, D58, G12