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Risk Sharing through Financial Markets with Endogenous Enforcement of Trades

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  • Thorsten V. Koeppl

Abstract

When people share risk in financial markets, intermediaries provide costly enforcement for most trades and, hence, are an integral part of financial markets' organization. We assess the degree of risk sharing that can be achieved through financial markets when enforcement is based on the threat of exclusion from future trading as well as on costly enforcement intermediaries. Starting from constrained efficient allocations and taking into account the public good character of enforcement we study a Lindahl-equilibrium where people invest in asset portfolios and simultaneously choose to relax their borrowing limit by paying fees to an intermediary who finances the costs of enforcement. We show that financial markets always allow for optimal risk sharing as long as markets are complete, default is prevented in equilibrium and intermediaries provide costly enforcement competitively. In equilibrium, costly enforcement translates into both agent-specific borrowing limits and price schedules that include a separate default premium. Enforcement costs - or, equivalently, default premia - increase borrowing costs, while the risk-free rate per se tends to be lower. This suggest a new route for analyzing pricing puzzles by linking agent-specific interest rates to different sources of borrowing costs

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Paper provided by Econometric Society in its series Econometric Society 2004 North American Winter Meetings with number 326.

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Date of creation: 11 Aug 2004
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Handle: RePEc:ecm:nawm04:326

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Keywords: Limited Commitment; Enforcement Intermediaries; Lindahl-equilibrium; Endogenous Borrowing Constraints;

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Cited by:
  1. Costas Azariadis & Leo Kaas, 2004. "Endogenous Financial Development and Multiple Growth Regimes," Economic Working Papers at Centro de Estudios Andaluces E2004/08, Centro de Estudios Andaluces.

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