Dissertation/Thesis Abstract

Essays on frictions in financial over-the-counter markets
by Zhang, Shengxing, Ph.D., New York University, 2014, 296; 3635319
Abstract (Summary)

My dissertation, "Essays on Frictions in Financial Over-the-Counter Markets", consists of three chapters analyzing frictions in financial over-the-counter markets.

In "Collateral Risk, Repo Rollover and Shadow Banking", I build a dynamic model of the shadow banking system that intermediates funds through the interbank repo market to understand its efficiency and stability. The model emphasizes a key friction: the maturity mismatch between the short-term repo and the long-term investment that banks need to finance. The haircut, interest rate, default rate of the repo contract and liquidity hoarding of banks are all determined endogenously in the equilibrium with repo rollover. And default is contagious. When collateral risk increases unexpectedly, the haircut and interest rate overshoot, triggering massive initial default and persistently hiking default rate and depressed investment.

In "A Model of Monetary Exchange in Over-the-Counter Markets" (a joint work with Professor Ricardo Lagos), we develop a model of monetary exchange in over-the-counter markets to study the effects of monetary policy on asset prices and standard measures of financial liquidity, such as bid-ask spreads, trade volume, and the incentives of dealers to supply immediacy, both by participating in the market-making activity and by holding asset inventories on their own account. The theory predicts that asset prices carry a speculative premium that reflects the asset's marketability and depends on monetary policy as well as the market microstructure where it is traded. These liquidity considertations imply a positive correlation between the real yield on stocks and the nominal yield on Treasury bonds-an empirical observation long regarded anomalous. The theory also exhibits rational expectations equilibria with recurring belief driven events that resemble liquidity crises, i.e., times of sharp persistent declines in asset prices, trade volume, and dealer participation in market-making activity, accompanied by large increases in spreads and abnormally long trading delays.

In "Market Runs: Liquidity and the Value of Information" ( a joint work with Klaus-Peter Hellwig), we study the interaction between an endogenous information structure and the market liquidity in an over-the-counter market with uncertain asset quality and find a new channel through which additional information can adversely affect market outcomes. Additional information may help investors overcome a lemons problem, but by changing the asset allocation, current information choice has an externality on liquidity in the future. Due to this externality, the market is vulnerable to self-fulfilling shifts in expectations about market liquidity if information is cheap. Such market runs have interesting transition dynamics in that the trade volumes and average prices overshoot: a total market freeze followed by a partial recovery. We also find that the aggregate level of information choice is generally not efficient even in times when a lemons problem makes markets illiquid. Agents fail to internalize the effect of their information acquisition on the future allocation and therefore overinvest. Finally, the incentives to invest in information and the strategic interactions in information choice depend on asset liquidity: in liquid equilibria, information choice is complementary between agents, whereas in illiquid markets, information choice decisions are strategic substitutes.

Indexing (document details)
Advisor: Lagos, Ricardo
Commitee: Gale, Douglas, Jovanovic, Boyan, Sargent, Thomas
School: New York University
Department: Economics
School Location: United States -- New York
Source: DAI-A 76/01(E), Dissertation Abstracts International
Subjects: Economics, Finance, Economic theory
Keywords: Liquidity, Maturity mismatch, Over-the-counter markets, Repurchase agreement, Search friction, Shadow banking
Publication Number: 3635319
ISBN: 978-1-321-16307-0
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