Optimal Debt Financing and the Pricing of Illiquid Assets
27 Pages Posted: 15 Mar 2011
Date Written: March 14, 2011
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: Suggested Citation