ESSAYS ON FINANCIAL MARKETS

This dissertation consists of three essays, the first two on the foreign exchange market and the third on credit markets. Chapter 2 examines empirically the exchange rate-interest differential relationship in a co-integration framework. We test and estimate an error correction model (ECM) for the currency pair US dollar and British pound at the daily frequency. The exchange rate and the interest differential are found to be co-integrated, and the parameters in the ECM exhibit signs that are consistent with market practitioners' observation concerning the relationship. The interest differential can thus be viewed as a long-run anchor for the two currencies' exchange rate. In Chapter 3, we model the direct inter-dealer trading in the foreign exchange market as a two-stage, alternating-offer bilateral bargaining game in an asymmetric information environment. Under the naïve conjecture rule for updating the uninformed dealer's beliefs, there exists a unique perfect Bayesian equilibrium (PBE) of the game. The PBE outcome depends on the informed dealer's valuation of the future exchange rate. An alternative bargaining procedure is also considered which produces an identical PBE outcome. In Chapter 4, we re-examine the problem of credit rationing by modeling the loan contracting problem between a monopolist lender and the borrowers as a two-stage screening game in which pre-contractural and post-contractural informational asymmetry are simultaneously present. The screening game has a unique subgame perfect equilibrium. Depending on the level of borrowers' prior debts, credit rationing may or may not occur. In the pooling equilibrium, there is no credit rationing and all borrowers get a loan whose size is socially efficient. Credit rationing arises in the semi-separating equilibrium in which high-debt borrowers do not obtain a loan from the lender