Koufopoulos, Konstantinos
(2003)
Equilibrium and optimal financial and insurance contracts under asymmetric information.
PhD thesis, London School of Economics and Political Science.
Abstract
This thesis studies financial and insurance markets under various specifications of asymmetric information. The opening chapter considers project financing under adverse selection and moral hazard. There are three main contributions. First, the issue of combinations of debt and equity is explained as the outcome of the interaction between adverse selection and moral hazard. Second, it shows that, in the presence of moral hazard, adverse selection may result in the conversion of negative into positive NPV projects leading to an improvement in social welfare. Third, it provides two rationales for the use of warrants. It also shows that, under certain conditions, a debt-warrant combination can implement the optimal contract as a competitive equilibrium. Chapter 2 examines insurance markets when some clients misperceive risk. Optimism may either increase or decrease precautionary effort and we show that this determines whether optimists or realists are quantity-constrained in equilibrium. Intervention may lead to a strict Pareto improvement on the laissez-faire equilibria. These results provide a more convincing justification for the imposition of minimum coverage requirements than standard models as well as a case for the use of taxes and subsidies in insurance markets. Chapter 3 focuses on the relationship between coverage and accident rates. In contrast to the prediction of competitive models of asymmetric information that if all agents buy at least some insurance there must be positive correlation between coverage and accident probability, some recent empirical studies find either negative or zero correlation. If optimism discourages precautionary effort there exist separating equilibria that potentially explain the puzzling empirical findings. It is also shown that zero correlation between coverage and risk does not imply the absence of barriers to trade in insurance markets. We conclude with some implications for empirical testing.
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