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Should regulators encourage the migration of trade from over-the-counter (OTC) to centralized markets? To address this question, we study a model in which banks make costly decisions to participate in an OTC market, a centralized market, or both markets at the same time. Banks differ in their ability to take large positions, what we call their trading capacity. In equilibrium, intermediate-capacity banks find it optimal to participate in the centralized market. In contrast, low- and high-capacity banks find it optimal to participate in the OTC market, due to an endogenous complementarity. Namely, low-capacity banks receive worse terms of trade than in the centralized market but better risk sharing, thanks to the intermediation services offered by high-capacity banks. High-capacity banks receive worse risk sharing than in the centralized market, but profit from the provision of intermediation services to low-capacity banks. While the social optimum has qualitatively similar participation patterns, it prescribes that more customers migrate to the centralized market, and that more dealers enter the OTC market. [ABSTRACT FROM AUTHOR]

To purchase or authenticate to the full-text of this article, please visit this link: http://dx.doi.org/10.1111/j.1467-937X.2007.00451.x Byline: PIERRE-OLIVIER WEILL (a) Abstract: During financial disruptions, market makers provide liquidity by absorbing external selling pressure. They buy when the pressure is large, accumulate inventories, and sell when the pressure alleviates. This paper studies optimal dynamic liquidity provision in a theoretical market setting with large and temporary selling pressure and order-execution delays. I show that competitive market makers offer the socially optimal amount of liquidity, provided they have access to sufficient capital. If raising capital is costly, this suggests a policy role for lenient central bank lending during financial disruptions. Author Affiliation: (a)University of California, Los Angeles Article History: First version received April 2006; final version accepted January 2007 (Eds.)

To link to full-text access for this article, visit this link: http://dx.doi.org/10.1016/j.jedc.2005.10.001 Byline: Stephane Gregoir (a), Pierre-Olivier Weill (b) Abstract: This paper studies a cobweb economy in which agents make decisions using a misspecified model of their stochastic environment. Specifically, the agents' model of the price process is restricted to be a moving average of order q (MA(q)), minimizing the mean square of their forecast error. We prove existence and uniqueness of this MA(q)-optimal equilibrium and we show that, as q goes to infinity, the MA(q)-optimal equilibrium converges in mean square towards the rational expectations equilibrium. The speed of convergence is dictated by the persistence of the underlying exogenous process. Lastly, we show that when all other agents use the correctly specified model, the misspecified MA(q) model can provide accurate forecasts. This suggests that, if agents have to pay for their forecasting model and if the correctly specified model is more costly, a situation in which all agents use the correctly specified model might not be an equilibrium. Author Affiliation: (a) CREST-INSEE, France (b) Finance Department, Stern School of Business, New York University, 44 West Fourth Street, Suite 9-190, New York, NY 10012, USA Article History: Received 18 April 2002; Accepted 6 October 2005

We study a canonical model of decentralized exchange for a durable good or asset, where agents are assumed to have time‐varying, heterogeneous utility types. Whereas the existing literature has focused on the special case of two types, we allow agents' utility to be drawn from an arbitrary distribution. Our main contribution is methodological: we provide a solution technique that delivers a complete characterization of the equilibrium, in closed form, both in and out of the steady state. This characterization offers a richer framework for confronting data from real‐world markets and reveals a number of new economic insights. In particular, we show that heterogeneity magnifies the impact of frictions on equilibrium outcomes and that this impact is more pronounced on price levels than on price dispersion and welfare. [ABSTRACT FROM AUTHOR]

Banks' ratio of the market value to book value of their equity was close to 1 until the 1990s, then more than doubled during the 1996–2007 period, and fell again to values close to 1 after the 2008 financial crisis. Some economists argue that the drop in banks' market-to-book ratio since the crisis is due to a loss in bank franchise value or profitability. In this paper we argue that banks' market-to-book ratio is the sum of two components: franchise value and the value of government guarantees. We empirically decompose the ratio between these two components and find that a large portion of the variation in this ratio over time is due to changes in the value of government guarantees. [ABSTRACT FROM AUTHOR]

We construct a continuous‐time new‐monetarist economy that displays an endogenous, nondegenerate distribution of money holdings. Properties of equilibria are obtained analytically and equilibria are solved in closed form in a variety of cases. Lump‐sum transfers financed with money creation are welfare‐enhancing when labor productivity is low whereas regressive transfers approach first best when labor productivity is high and agents are not too impatient. We introduce illiquid government bonds and draw implications for liquidity‐trap equilibria. We also study transitional dynamics under quadratic preferences and the velocity of money under heterogeneous preference shocks. [ABSTRACT FROM AUTHOR]

Building on the Merton (1974) and Leland (1994) structural models of credit risk, we develop a simple, transparent, and robust method for measuring the financial soundness of individual firms using data on their equity volatility. We use this method to retrace quantitatively the history of firms' financial soundness during U.S. business cycles over most of the last century. We highlight three main findings. First, the three worst recessions between 1926 and 2012 coincided with insolvency crises, but other recessions did not. Second, fluctuations in asset volatility appear to drive variation in firms' financial soundness. Finally, the financial soundness of financial firms largely resembles that of nonfinancial firms. [ABSTRACT FROM AUTHOR]

We develop a model of equilibrium entry, trade, and price formation in over-the-counter (OTC) markets. Banks trade derivatives to share an aggregate risk subject to two trading frictions: they must pay a fixed entry cost, and they must limit the size of the positions taken by their traders because of risk-management concerns. Although all banks in our model are endowed with access to the same trading technology, some large banks endogenously arise as "dealers," trading mainly to provide intermediation services, while medium sized banks endogenously participate as "customers" mainly to share risks. We use the model to address positive questions regarding the growth in OTC markets as trading frictions decline, and normative questions of how regulation of entry impacts welfare. [ABSTRACT FROM AUTHOR]

We study an over-the-counter OTC market in which the usefulness of assets as a means of payment or collateral is limited by the threat of fraudulent practices. Agents can produce fraudulent assets at a positive cost, which generates upper bounds on the quantity of each asset that can be traded in the OTC market. Each of these endogenous, asset-specific, resalability constraints depends on the cost of fraud, on the frequency of trade, and on the asset price. In equilibrium, assets are partitioned into three liquidity tiers, which differ in their resalability, prices, haircuts, sensitivity to shocks, and responses to policies. [ABSTRACT FROM AUTHOR]

We study a competitive dynamic financial market subject to a transient selling pressure when market makers face a capacity constraint on their number of trades per unit of time with outside investors. We show that profit-maximizing market makers provide liquidity in order to manage their trading capacity constraint optimally over time: they use slack trading capacity early to accumulate assets when the selling pressure is strong in order to relax their trading capacity constraint and sell to buyers more quickly when the selling pressure subsides. When the trading capacity constraint binds, the bid–ask spread is strictly positive, widening and narrowing as market makers build up and unwind their inventories. Because the equilibrium asset allocation is constrained Pareto-optimal, the time variations in bid–ask spread are not a symptom of inefficient liquidity provision. [ABSTRACT FROM AUTHOR]