A Model of Efficiency and Trading Opportunities in Financial Markets by Chunyan Jennifer

This paper considers an economy with heterogeneous investors and an incomplete securities market. Investors have non-traded income and private information about security payoffs. They trade in the market to allocate the risk from their non-traded income and to speculate on security payoffs. We use the model to examine the equilibrium allocation of risk and the behavior of security prices under different market structures, as defined by the characteristics of all traded securities in the market. In particular, we examine how the addition of derivatives securities affects the trading and prices of existing securities and both the allocational and informational efficiencies of the market. We show that the introduction of derivatives can decrease informational efficiency of the market on security payoffs, increase risk premium and price volatility in the market. Thesis Supervisor: Jiang Wang Title: Professor of Finance, Sloan School of Management Thesis Supervisor: Frank T. Leighton Title: Professor of Mathematics, Department of Mathematics Acknowledgments This thesis is a collaborative effort with Professor Jiang Wang, to whom I owe a great deal of debt. Were it not for his brilliant insights, patient guidance and generous support, this thesis would probably not have progressed very far at all. He introduced me to the fascinating world of asset pricing. More importantly, he showed me how to approach it with an open mind. The opportunity to be his student is an experience I shall forever treasure. I would also like to thank Professor Frank T. Leighton for his class on parallel algorithm which is the best introduction to the field. Also I thank him for financial support through research assistantship and for his support of my interest in finance. I thank Phyllis Black, Maureen Lynch, and Sharon Cayley for their help in all the administrative work and system manager Larry Nolan for installing new softwares which made programming much easier. Thanks also goes to all my friends who have enlivened my time at MIT, especially Andrew Chou, Harrison Hong, Yuan Ma, Jianhong Shen, Ethan Wolf, Haiyan Wu, and Yiqun Ying. I especially thank Harrison for many beneficial discussion regarding the thesis. I am grateful for the financial support from mathematics department through teaching assistantship over the three years and I thank the summer support from the Taiwan Program at MIT which made this thesis possible. Finally, I would like to thank my parents and brother for their love and support through the years. Most of all, I thank Ge Li. It was his support that gave me the courage to pursue my real interest; it was his faith in me that kept me going in the most depressing periods: and it was his love that made the winter of Boston a lot warmer.