Dynamic Liquidity-Based Security Design

37 Pages Posted: 31 Jul 2018

See all articles by Emre Ozdenoren

Emre Ozdenoren

London Business School; Centre for Economic Policy Research (CEPR)

Kathy Yuan

London School of Economics & Political Science (LSE) - Department of Finance

Shengxing Zhang

London School of Economics & Political Science (LSE) - London School of Economics

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Date Written: July 2018

Abstract

Abstract We study a dynamic problem of the design and sale of a security backed by a long-lived asset. The dividend payment on the asset may be high or low. Issuers are privately informed about the quality of the asset, and raise capital by securitizing part of it to fund a productive technology. Issuers can pledge not only the current period payoff from the assets, but also the future resale price. There is a dynamic feedback loop between the future asset price and today's issuers' decision where both adverse selection and the productivity level determine the liquidity of the security. Multiple dynamic - liquid and illiquid - equilibria might arise when only equity contracts can be issued. We characterize the optimal security design and demonstrate short-term liquid collateralized debt, or short-term repo, is optimal and eliminates the multiple equilibria fragility. In fact, the unique equilibrium under debt contract improves social welfare relative to the illiquid equity equilibrium.

Keywords: financial fragility, liquidity, repo, security design

JEL Classification: G01, G10

Suggested Citation

Ozdenoren, Emre and Yuan, Kathy Zhichao and Zhang, Shengxing, Dynamic Liquidity-Based Security Design (July 2018). CEPR Discussion Paper No. DP13069, Available at SSRN: https://ssrn.com/abstract=3222580

Emre Ozdenoren (Contact Author)

London Business School ( email )

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Centre for Economic Policy Research (CEPR)

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Kathy Zhichao Yuan

London School of Economics & Political Science (LSE) - Department of Finance ( email )

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Shengxing Zhang

London School of Economics & Political Science (LSE) - London School of Economics ( email )

United Kingdom

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