Optimal Debt Financing and the Pricing of Illiquid Assets

27 Pages Posted: 15 Mar 2011

See all articles by Antonio E. Bernardo

Antonio E. Bernardo

University of California, Los Angeles (UCLA) - Finance Area

Ivo Welch

University of California, Los Angeles (UCLA); National Bureau of Economic Research (NBER)

Date Written: March 14, 2011

Abstract

We develop a model in which the equilibrium returns of illiquid assets are determined by the debt capacity of arbitrageurs rather than the desire to smooth consumption shocks. Debt allows risk-neutral arbitrageurs to earn a spread between the asset's expected cash flow and its equilibrium price, but increases the likelihood they will be unable to meet a margin call in which case they are forced to liquidate the asset at a discount to its fundamental value. We show that the costs of debt are convex and impose a "limit to arbitrage." Consequently, even though arbitrageurs are risk neutral, the asset earns a risk premium in equilibrium and the risk premium is larger when the aggregate debt capacity among the arbitrageurs is smaller. In particular, the asset's risk premium is larger when the asset is more illiquid, margin constraints are tighter, and expected money flows to the arbitrageurs is low.

Keywords: Liquidity, Returns, Volatility, Limits to Arbitrage

JEL Classification: G12, G32

Suggested Citation

Bernardo, Antonio E. and Welch, Ivo, Optimal Debt Financing and the Pricing of Illiquid Assets (March 14, 2011). Available at SSRN: https://ssrn.com/abstract=1785902 or http://dx.doi.org/10.2139/ssrn.1785902

Antonio E. Bernardo (Contact Author)

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-2198 (Phone)
310-206-5455 (Fax)

Ivo Welch

University of California, Los Angeles (UCLA) ( email )

110 Westwood Plaza
C519
Los Angeles, CA 90095-1481
United States
310-825-2508 (Phone)

HOME PAGE: http://www.ivo-welch.info

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

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