How people Borrow: Properties and Interactions of Financial Instruments

On the whole, this thesis studies the different ways people can borrow, such as unsecured debt contracts and various types of secured debt contracts, and aims to explore how they interact with each other, and what implications this has for the pricing of the underlying assets in the economy, and for economic equity.

The first chapter builds a general equilibrium model where both secured and unsecured debt contracts are available for trade and analyzes this model to prove the existence and determine the nature of equilibria. I define a coexistence equilibrium in this economy as an equilibrium that involves active trade in both secured and unsecured debt, and study the conditions sufficient to guarantee its existence. This paper combines endogenous leverage with the anonymity of perfectly competitive markets to present a scenario where coexistence arises endogenously. I connect this behavior to the existence of endowment inequalities, and illustrate how this inequality affects agents' portfolio decisions between the two types of debt. Finally, by comparing equilibria across financial structures where only one or both kinds of contracts are available, I also demonstrate the asset pricing and redistributive implications of these results.

The second chapter studies the effect of collateral-based financial innovation in a general equilibrium model with incomplete markets and provide precise predictions about asset price effects and spillovers. We define financial innovation is the use of new kinds of collateral or new kinds of promises backed by existing collateral. Whereas leverage and tranching have positive effects on the price of the underlying asset, credit-default swaps (CDS) has negative price effects. On the other hand, leverage has positive price spillovers on other markets, but tranching and CDS have negative price spillovers. Our results underscore a new mechanism (collateral-based financial innovation) that can explain asset price spillovers without relying on traditional (fire-sale/contagion) channels.