Secondary Market Liquidity and Security Design: Theory and Evidence from ABS Markets

40 Pages Posted: 25 Aug 2015  

Nils Friewald

Norwegian School of Economics (NHH)

Chris Hennessy

London Business School

Rainer Jankowitsch

WU (Vienna University of Economics and Business)

Date Written: August 18, 2015

Abstract

We develop a theory of primary market discounts demanded by ex ante identical strategic uninformed investors facing heterogeneous carrying cost realizations. Such investors demand primary market discounts equaling expected secondary market trading losses plus carrying costs. Security design is shown to complement strategic trading ability, as repackaging cash flow gives uninformed investors flexible exit options. Issuers minimize discounts by splitting cash flow into tranched debt claims, with secondary market liquidity increasing in seniority. The optimal number of tranches increases with cash flow information-sensitivity and decreases with carrying costs. Deadweight loss is socially excessive due to excessively thin tranches. Consistent with the model, empirical tests confirm ABS trading costs decrease and trading volume increases with seniority, while the number of tranches increases with information-sensitivity.

Suggested Citation

Friewald, Nils and Hennessy, Chris and Jankowitsch, Rainer, Secondary Market Liquidity and Security Design: Theory and Evidence from ABS Markets (August 18, 2015). Available at SSRN: https://ssrn.com/abstract=2649929 or http://dx.doi.org/10.2139/ssrn.2649929

Nils Friewald

Norwegian School of Economics (NHH) ( email )

Helleveien 30
Bergen, NO-5045
Norway

Christopher Hennessy (Contact Author)

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

Rainer Jankowitsch

WU (Vienna University of Economics and Business) ( email )

Welthandelsplatz 1
Vienna, Vienna AT1020
Austria
+43 1 31 336 4340 (Phone)
+43 1 310 0580 (Fax)

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