This paper examines financial market equilibrium in the presence of a large investor, such as a pension fund, who has access to a costly monitoring technology allowing him to affect securities’ expected payoffs. Despite the free-rider problem that arises because small shareholders enjoy the benefits but do not incur the costs of monitoring, risk-sharing considerations lead to equilibria in which monitoring is done even when the large investor is not initially endowed with shares. We characterize the equilibrium allocations and the monitoring levels under various assumptions about the trading environments. We show that under certain conditions all investors hold the market portfolio of risky assets even when monitoring is possible. In other cases the large investor deviates from holding the market portfolio and might carefully engage in monitoring activities that reduce the expected payoffs on the market portfolio.
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