Adverse selection

Summary

In economics, insurance, and risk management, adverse selection is a market situation where buyers and sellers have different information. The result is the unequal distribution of benefits to both parties, with the party having the key information benefiting more. In an ideal world, buyers should pay a price which reflects their willingness to pay and the value to them of the product or service, and sellers should sell at a price which reflects the quality of their goods and services. For example, a poor quality product should be inexpensive and a high quality product should have a high price. However, when one party holds information that the other party does not have, they have the opportunity to damage the other party by maximizing self-utility, concealing relevant information, and perhaps even lying. Taking advantage of undisclosed information in an economic contract or trade of possession is known as adverse selection. This opportunity has secondary effects: the party without

Official source

https://en.wikipedia.org/wiki/Adverse_selection

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Essays in Corporate Finance

Thomas Antonius Geelen

In this thesis I study how firms choose their optimal debt maturity. The recent financial crisis illustrated why debt maturity is an important determinant of firmsâ capital structure and it also renewed economistsâ interest in this topic, see for example Brunnermeier and Oehmke (2013), He and Milbradt (2016), Ju and Ou-Yang (2006), Crouzet (2016), and Huang et al. (2017). This thesis exists of two chapters. In the first chapter, titled âInformation Dynamics and Debt Maturityâ, I develop a dynamic model of financing decisions and optimal debt maturity choice in which creditors face adverse selection and learn about the firmâs quality from news. In equilibrium, shareholders may choose to postpone debt issuance to reduce adverse selection and improve the pricing of newly issued debt. Over time, the benefits of learning decrease and zero-leverage firms eventually decide to issue debt. Because shorter maturity debt is less sensitive to information, younger firms issue shorter maturity debt to alleviate adverse selection while mature firms issue longer maturity debt, leading to a life-cycle theory of debt maturity. In the second chapter, titled âDebt Maturity and Lumpy Debtâ, I develop a dynamic capital structure model in which shareholders determine a firmâs leverage ratio, debt maturity, and default strategy. In my model, the firmâs debt matures all at once. Therefore, after repaying the principal shareholders own all the firmâs cash flows and can pick a new capital structure. The possibility to alter the capital structure at maturity gives shareholders the incentive to issue finite maturity debt and allows me to study firmsâ joint choice of leverage and debt maturity. I also extend my model by allowing for time-varying capital supply to study time-variation in firmsâ joint choice of leverage and debt maturity.

EPFL2018

This thesis is structured in three chapters, each pertaining to a specific problem in financial economics. The first chapter, titled 'High-Frequency Jump Analysis of the Bitcoin Market' and co-authored with Prof. Olivier Scaillet and Adrien Treccani of the University of Geneva, studies the market for bitcoin, a pioneer virtual currency, and its price dynamics. Using data for all the trades that took place on the exchange Mt. Gox during the period June 2011 to November 2013, we analyse the occurrence of jumps in the price process and conclude that they are frequent (one jump per week, on average) and that they tend to cluster in time. They are predicted by the order flow imbalance and the preponderance of aggressive traders. Jumps have a short-term positive impact on market activity and illiquidity and see a persistent change in the price. The second chapter, titled 'Price Formation in the Bitcoin Market', studies the same bitcoin market from the point of view of information and the way it is incorporated in the price. I analyse different measures of liquidity and price impact and find that bitcoin exhibits more adverse selection than comparable stocks. I examine the potential profits of liquidity provision and conclude that they are insufficient, which explains the absence of market makers and consequently the low market depth. I estimate a vector autoregressive model for the returns and a trade indicator and find that the effect of past returns and past trades on contemporaneous trades is significant and singular, indicating that agents infer considerable information which leads them to update their beliefs about the future evolution of the price, consistent with the view that bitcoin is a Keynesian beauty contest. The third chapter, titled 'Cash Holdings and Credit Risk', investigates the a priori surprising empirical phenomenon that firms with larger cash holdings appear to be riskier with regards to the valuation of their debt. It is explained by the endogeneity affecting the relation between a firm's cash holdings and credit spread. Indeed, a firm facing more risk (for instance, because its cash flows are more volatile) will optimally choose larger cash holdings as a hedge. I review the related literature and present a class of continuous-time capital structure models capable of capturing this phenomenon.

EPFL2016

We provide a theoretical rationale for dealer objections to ex post transparency in over-the-counter markets. Disclosure of the terms of a transaction conveys information possessed by the dealer about the asset quality and reduces the dealer's rents when she disposes of the inventory in a second transaction. We show that costly signaling in a transparent market benefits investors through lower spreads and higher volume. Dealers may also gain from transparency despite lower spreads when potential gains from trade are small or adverse selection is high, because in those circumstances higher volume offsets smaller spreads for dealer profits.

CAMBRIDGE UNIV PRESS2020

EPFL2016