Government Safety Net, Stock Market Participation and Asset Prices

This paper studies the effect on equilibrium prices adventing from the presence of a safety net during financial crises. It is shown that, by inflating prices with the insurance provided through its intervention policy, a government might be sowing the seeds of a crisis that its intention is to prevent in the first place. The model developed is one with risk-neutral agents facing a static decision problem, under different (i) frameworks - with and without the possibility of intervention - and (ii) informational scenarios - imperfect, perfect and common prior information. Intervention occurs whenever the combined return of those in the market goes below a certain threshold. By having different frameworks and scenarios, the impact of the safety net on a diverse class of assets can be studied. Equilibrium prices are shown to be always higher in the framework with the possibility of intervention, regardless of the informational scenario. There is a limit on price inflation, however, since an equilibrium fails to exist in those instances where high prices indicate an intervention to be imminent. The effect on prices of an increase in the degree of uncertainty turns out to be dependent on the supply level of the asset.