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Risk, Adverse Selection and Capital Market Failure

  • de Meza, David
  • Webb, David

This paper investigates the implications of adverse selection for capital market equilibrium when borrowers are risk averse. K. J. Arrow and R. C. Lind (1970) argue that when capital markets fail to spread risk properly interest rates are too high. The market adds a risk premium that the social planner would not. This paper shows that when projects differ in quality, in a pooling equilibrium, the private market sets interest rates too low even accounting for the risk premium. Hence, there is overinvestment. The result is shown to be robust to the introduction of moral hazard. Copyright 1990 by Royal Economic Society.

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Article provided by Royal Economic Society in its journal The Economic Journal.

Volume (Year): 100 (1990)
Issue (Month): 399 (March)
Pages: 206-14

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Handle: RePEc:ecj:econjl:v:100:y:1990:i:399:p:206-14
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