OTC markets exhibit a core-periphery network: 10-30 central dealers trade frequently and with many dealers, while hundreds of peripheral dealers trade sparsely and with few dealers. Existing work rationalize this phenomenon with exogenous dealer heterogeneity. We build a search-based model of network formation and propose that a core-periphery network arises from specialization. Dealers endogenously specialize in di↵erent clients with di↵erent liquidity needs. The clientele di↵erence across dealers, in turn, generates dealer heterogeneity and the core-periphery network: The dealers specializing in clients who trade frequently form the core, while the dealers specializing in buy-and-hold investors form the periphery.
A basic tenet of lognormal asset pricing models is that a risky currency is associated with a low pricing kernel volatility. Empirical evidence implies that a risky currency is associated with a relatively high interest rate. Taken together, these two statements associate high-interest-rate currencies with low pricing kernel volatility. We document evidence suggesting that the opposite is true. We approximate the volatility of the pricing kernel with the volatility of the short-term interest rate. We find that, across currencies, relatively high interest rate volatility is associated with relatively high interest rates. This contradicts the prediction of lognormal models. One possible reason is that our approximation of the volatility of the pricing kernel is inadequate. We argue that this is unlikely, in particular for questions involving currencies. We conclude that lognormal models of the pricing kernel are inadequate for explaining currency risk and that future work should place increased emphasis on distributions that incorporate higher moments.
I build a search model of bond and credit default swap (CDS) markets with endogenous investor participation and show that shorting bonds through CDS increases the liquidity and price of bonds. By allowing investors to trade the credit risk of bonds without trading the bonds, CDS introduction expands the set of feasible trades and attracts investors into the credit market. Because search is nondirected within the credit market, new investors also trade bonds and consequently increase their price and liquidity. My results suggest that naked CDS bans increased sovereigns’ borrowing costs and thereby exacerbated the 2010–2012 European debt crisis.
This paper studies how a lender's credit insurance activities affect a sovereign borrower in an environment with moral hazard and debt renegotiation. The moral hazard problem arises from the assumption of private information where the lender cannot observe if the sovereign invested or consumed the borrowed funds. We show that insurance serves as a commitment device for the lender. An insured lender has more bargaining power during debt reduction renegotiations and this enables him to extract more from the borrower. Thus, the existence of an insurance market alleviates the moral hazard problem by better aligning the incentives of the lender and the borrower.We also analyze the effect of naked buyers who do not lend directly to the sovereign.Our analysis shows that the market structure of the insurance market matters: if the market is imperfectly competitive, the existence of naked buyers can impede the alleviation of moral hazard.JEL Classification: E44, F34, G22, G30
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