Essays on Financial Markets Theory

This thesis examines three different, self-contained topics in Financial Markets Theory. In the fi rst chapter, we present a model of fi nancial intermediation, in which misperception of small probability events determines the allocation of systematic risk in an economy. Particularly, we analyse an economy where households can invest directly in projects or indirectly via bank deposits. We show that, when households overweight the probability of an unlikely bad state, they prefer to invest through deposits, thus allocating systematic risk to the fi nancial sector. Although this creates financial fragility in the market, it insures households as they are less exposed to risk. Furthermore, we examine any demand externalities that arise due to the households' investment decision and how they affect the real economy. In the second chapter, we develop a model of entrepreneurial fi nance in which financiers search entrepreneurs in two financial markets. The key assumption of the model is that markets are heterogeneous with respect to the number of entrepreneurs located in each one. From a financier's perspective, the market with the higher number of entrepreneurs gives a higher chance of finding an entrepreneur, and thus it is perceived to be larger compared to the other. We identify the conditions such that fi nanciers tend to overcrowd the larger market leaving the other one with potential undermatched entrepreneurs. We show that over-concentration of fi nanciers in one market may lead to excessive systematic risk in the economy and to higher financial fragility. Thus, asymmetry in the size of fi nancial markets may accentuate systematic risk and it is one systemic variable that policy makers need to take into consideration. In the final chapter, we study Bayesian persuasion in a strategic environment, where a seller wishes to influence a buyer to buy a security. When the two agents share a common prior belief, we characterise the optimal signals. The novel feature of our model is that we also allow the buyer to strategically choose her own prior ex-ante. We find that a pessimistic prior belief is optimal and that as the buyer becomes more sceptical, the seller is more prone to truthful communication. Both evolutionary and psychological interpretations are discussed.