Optimal Financial‐Market Integration and Security Design*

We study 2-period pure-exchange Capital Asset Pricing Model (CAPM) economies with incomplete financial markets and restricted participation. We characterize the optimal financial-market structure and efficient innovations consisting of both the introduction of new assets and the integration of segmented markets. Welfare gains from innovations are maximal when the endowments of affected agents are negatively correlated. Uncoordinated innovations lead to efficient market structures if all assets have identical participation structure or the markets being integrated trade identical assets. However, coordination failure in the introduction of new assets may result when assets have participation structures that overlap only partially.