Finance and Economics Discussion Series (FEDS)

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June 2019

Mixed Signals: Investment Distortions with Adverse Selection

R. Matthew Darst and Ehraz Refayet

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.

Accessible materials (.zip)

Keywords: asymmetric information, cost of capital, credit defaul swaps, investment, pecuniary externality, signalling

DOI: https://doi.org/10.17016/FEDS.2019.044

PDF: Full Paper

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Last Update: January 09, 2020