This project has two main objectives. The first is to understand why commonly used securities do not contain the kinds of contingencies that theory suggests are needed for efficient risk- sharing. In particular, we do not observe securities, such as income bonds, that make payoffs contingent on readily available accounting information. The project explores a number of possible explanations for these phenomena. The second objective is to extend earlier work by the investigators on the incentives to introduce new securities and the principals that should guide their design, to get a deeper understanding of the market institutions that promote efficient innovation. The project emphasizes the question of why there is a tendency to standardize contracts or securities. This pathbreaking work is opening up a new and important line of research in financial economics and it could eventually change the way markets are studied. Economic theorists have shown empirically that markets are incomplete and theoretically that this incompleteness can lead to inefficient decisions and market instability. But most of the past research starts by assuming incomplete markets, while this project shows that it is possible to explain the specific features of incomplete financial markets (e.g., no income bonds, use of a few standard securities) as the consequences of rational behavior under uncertainty. The research also promises useful new insights into the relationship between managerial incentive contracts and stock prices. The types of general equilibrium models developed by these investigators for the study of the microstructure of financial markets could eventually be used to study other types of incomplete markets.
