Working Paper

Mixed Signals: Investment Distortions with Adverse Selection

Abstract: We study how adverse selection distorts equilibrium investment allocations in a Walrasian credit market with two-sided heterogeneity. Representative investor and partial equilibrium economies are special cases where investment allocations are distorted above perfect information allocations. By contrast, the general setting features a pecuniary externality that leads to trade and investment allocations below perfect information levels. The degree of heterogeneity between informed agents' type governs the direction of the distortion. Moreover, contracts that complete markets dampen the impact of pecuniary externalities and change equilibrium distortions. Implications for empirical design in credit market studies and financial stability are discussed.

Keywords: Asymmetric Information; Cost Of Capital; Credit Default Swaps; Investment; Pecuniary Externality; Signalling;

JEL Classification: D52; D53; D82; E44; G32;

https://doi.org/10.17016/FEDS.2019.044

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2019-06-21

Number: 2019-044