The Economics of Financial Markets and Institutions : From First Principles

## Abstract This manuscript is based on introductory lectures on financial economics that the author delivered to masters students in the Faculty of Law at the University of Oxford. The book approaches financial economics as an application of general economic theory to both financial markets and financial institutions. Accordingly, it presents both the general economic theory and its financial applications. The presentation is formal and rigorous, though the mathematics is simplified to the bare minimum. Formal analysis results in models that can be tested against real data (positive analysis), but can also be used as a basis for policy design (normative analysis). Unregulated (spontaneous) interaction serves as an interesting benchmark to the normative analysis, without pre-supposing that it is the most economically efficient arrangement. Cover Titlepage Copyright Preface Contents Introduction On Mathematical Modelling On Abstraction 1 Making (Rational) Decisions 1.1 Introduction 1.2 From Sentiment to Quantified Subjective Valuation 1.3 The Subjective Value of Time 1.3.1 Arbitrage 1.3.1.1 Discounting 1.3.2 The Net-Present-Value (NPV) Formula 1.4 An Application: Rational Drug Addiction 1.4.1 The Decision Tree of a Potential Drug Addict 1.4.2 Rational Decisions 1.4.3 Practical Implications 1.4.4 Backward Induction 1.5 Opportunity Costs 1.6 Revealed Preferences 1.6.1 Lending and Borrowing Decisions 1.6.2 The Revealed-Preference Principle 1.7 Decreasing Unit Subjective Valuation (DUSV) 1.8 A Note on the Indexing of Commodities 1.9 Attitudes towards Risk 1.9.1 The Allais Paradox 1.9.2 The Subjective Valuation of Risk Attitudes 1.9.3 Behavioural Finance 1.10 Positive Economics 1.11 Correlation and Causality 1.12 Conclusion References 2 Cutting Deals (the Coase Theorem) 2.1 Introduction 2.2 Economic Efficiency 2.3 Rubinstein's Alternating Offers Bargaining Game 2.3.1 Building Up Intuition: A Simpler Game 2.3.2 Non-credible threats 2.4 Equilibrium in the Alternating-Offers Game 2.4.1 Equilibrium for the T=1 Game 2.4.2 Equilibrium for the T=2 Game 2.4.3 Equilibrium for the T→∞ Game 2.5 Taking a Shortcut: Nash Bargaining 2.6 The Coase Theorem 2.6.1 Frictions: A Simple Example 2.6.2 Frictions: Preliminary Discussion 2.6.3 Ex-Post versus Ex-Ante Economic Efficiency 2.7 A Note on Equilibria in Games 2.8 Application: Insolvency Law 2.8.1 Financial and Economic Distress 2.8.2 Debt Overhang 2.8.3 Debt Forgiveness 2.8.3.1 Debt-for-Equity Swaps 2.9 The Limits of Freedom of Contracting 2.9.1 Third Parties 2.9.2 Private Benefits and Liquidity 2.9.3 Activist Courts and the Availability of Credit 2.9.4 Uncoordinated Creditors: Creditors Run 2.10 Conclusion References 3 Property Rights 3.1 Introduction 3.2 The Nature of the Firm 3.2.1 An Outline of a Theory 3.2.2 Relationships: Weak and Strong 3.3 Technological Complementarities and Synergies 3.4 Joint Ownership and Synergies 3.4.1 Contract and Property 3.4.2 Buy Outs 3.4.3 A Reconsideration of the GM–FB Case 3.4.4 An Empirical Test of the Theory 3.5 Property Rights and Secured Debt 3.5.1 Contracts and Capital Structure 3.5.2 A Theory of Security Interests 3.6 Trade in a Lawless Environment: Reputation 3.7 Conclusion References 4 Competitive Markets 4.1 Introduction 4.2 Perfect Competition 4.2.1 A Note on Profit Maximization 4.3 Supply and Demand Curves 4.3.1 `Shifts' on and of Supply and Demand Curve 4.3.2 Diversion: Elasticity of Demand 4.4 Market Equilibrium 4.4.1 Stability of Equilibrium 4.4.2 Welfare Theorems 4.4.3 Tax Distortions and Lump-sum Taxes 4.4.4 Endogenous and Exogenous Variables 4.5 `Free Trade' 4.5.1 Trade Liberalization 4.5.2 A note on Coase, Pareto, Spontaneous Order and the State 4.5.3 David Ricardo's Comparative Advantage Theory 4.6 Fitting Data: Estimating Supply and Demand Curves 4.7 Applications 4.7.1 The Effect of Import Quotas on the US Economy 4.7.2 The Effect of Climate Change on Farmers Income 4.7.3 Environments with Both Strategic and Market Interactions: `Fire Sales' 4.8 Conclusion References 5 The Market for Risk 5.1 Introduction 5.2 The Description of Uncertainty 5.3 The Market for Risk 5.3.1 Linear Demand Functions 5.3.2 Risk Aversion and the Demand Function 5.4 Insurance and Investment 5.5 Market Equilibrium and the Motives for Trade 5.5.1 Trade Driven by Differences in Exposure 5.5.2 Trade Driven by Different Attitudes towards Risk 5.5.3 Trade Driven by Different Beliefs 5.6 Normative Analysis 5.7 Empirical Tests of Risk Sharing 5.8 Arbitrage, Arrow-Debreu Securities, and Complex Securities 5.9 Some Classic Results 5.9.1 The Modigliani–Miller Theorem 5.9.2 Derivative Pricing 5.9.3 The Capital Asset Pricing Model (CAPM) 5.9.3.1 CAPM and Idiosyncratic Risk 5.9.3.2 Selling Short 5.10 The Equity-Premium Puzzle 5.11 A Note on the Tradeoff Theory 5.12 Conclusions References 6 Market Failures 6.1 Introduction 6.2 Imperfect Competition 6.2.1 Perfect Competition in More Detail 6.2.1.1 Cost Structure of Firms 6.2.1.2 Competitive Structure in the Short Run and in the Long Run 6.2.2 Monopoly 6.2.3 Causes for Monopolization 6.2.3.1 Natural Monopoly 6.2.4 Oligopoly 6.2.4.1 Bertrand Duopoly 6.2.4.2 Cournot Duopoly 6.2.4.3 A Note on Oligopoly and Product Differentiation 6.2.5 More Regulation-Sceptical Arguments 6.2.5.1 Schumpeter: Monopoly and Technological Innovation 6.2.5.2 Regulatory Capture 6.3 Missing Markets 6.3.1 The Textbook Case: Emission 6.3.1.1 Policy Responses 6.3.1.2 Social Valuation 6.3.1.3 Public Goods 6.3.2 The Identification of Market Failures 6.3.2.1 Lighthouses 6.3.2.2 The Fable of Bees 6.3.3 Information as a Public Good 6.3.3.1 Health Care 6.3.3.2 Costly State Verification 6.3.3.3 Some Empirical Evidence 6.3.3.4 The `Hirshleifer Effect' 6.3.4 Liquidity 6.4 Conclusions References 7 Trading with the Better Informed 7.1 Introduction 7.2 Asymmetric Information: Taxonomy 7.3 The Hidden-Type Problem 7.3.1 The Market for Lemons 7.3.2 Education as a Signal 7.3.2.1 Full Information Benchmark 7.3.2.2 Separating Equilibria 7.3.2.3 Pooling Equilibria 7.3.2.4 Economic Efficiency in Adverse Selection Models 7.3.3 Application: Debt and Equity 7.4 The Hidden Action Problem 7.4.1 Full Information Benchmark 7.4.2 Hidden Effort: Incentive Compatibility 7.4.3 Solving the Contract Problem with Hidden Effort 7.4.4 Implications 7.4.5 Alternative Interpretation of the Hidden Effort Problem 7.4.5.1 Private Benefits of Control 7.4.5.2 Cash Diversion 7.4.6 Application: Internal and External Funding 7.4.7 Application: The Savings and Loans Crisis in 1980s US 7.4.8 Application: The Firm as a Nexus of Contracts 7.4.9 Contracts, Markets, and Credit Rationing 7.5 Conclusion References 8 Learning from Trading 8.1 Introduction 8.2 Motivation: Learning from Trade 8.3 Signals and Their Precision 8.4 Information Efficiency 8.5 Competitive Rational-Expectations Equilibria 8.5.1 The `No-trade' Result 8.5.2 Conceptual Problems with the RE Equilibrium 8.5.3 Empirical Testing 8.6 Sequential Updating and Information Cascades 8.7 Sequential Markets 8.7.1 Bid-Ask Spreads (I) 8.8 Noise Trading 8.8.1 Bid-Ask Spreads (II) 8.9 The Martingale Property 8.10 Herding and Bubbles 8.11 Information Efficiency and Economic Efficiency 8.12 Concluding Remarks References Mathematical Appendix A.1 The Sum of an Infinite Geometric Series A.2 Functions and Graphs A.2.1 Notation A.3 Probability A.3.1 Random Variables A.3.2 Joint Distributions A.3.3 Conditional Means and Bayes Law A.4 Statistics: Sampling A.5 Linear Regression A.5.1 Hypothesis Testing A.5.2 Dummy Variables A.5.3 R-squared A.5.4 Non-linear Specifications A.5.5 Interpretation of Regression Results Index The Economics of Financial Markets and Institutions is based on introductory lectures on financial economics delivered to master students in law in the Department of Law at the University of Oxford. The aim is to keep the levels of mathematical complexity to a minimum while, at the same time, to aim high, conceptually, emphasizing the close links between financial and economic analysis. The book assumes no previous knowledge of economics; rather economic concepts are developed from first principles, then applied, up front, to the analysis of financial markets and institutions. Though aimed, originally, at an audience of lawyers, the book is suitable for anyone interested in a better understanding of the rich and complex institutional structure of financial markets.