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 limits 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 interest rates per se depend on the change in enforcement over time.
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Paper provided by Queen's University, Department of Economics in its series Working Papers with number
1048.
Length: 41 pages Date of creation: Dec 2004 Date of revision: Publication status: Forthcoming in Journal of Economic Dynamics and Control Handle: RePEc:qed:wpaper:1048
Find related papers by JEL classification: C73 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Stochastic and Dynamic Games; Evolutionary Games D60 - Microeconomics - - Welfare Economics - - - General G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data) H41 - Public Economics - - Publicly Provided Goods - - - Public Goods K42 - Law and Economics - - Legal Procedure, the Legal System, and Illegal Behavior - - - Illegal Behavior and the Enforcement of Law
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