Repurchase Options in the Market for Lemons
49 Pages Posted: 10 Oct 2020
Date Written: August 19, 2020
We study repurchase options (repo contracts) in a competitive asset market with asymmetric information. Gains from trade emerge from a liquidity need, but private information about asset quality prevents the full realization of trade. We obtain a unique equilibrium, which features a pooling repo contract and full participation among borrowers. The equilibrium repo contract resolves adverse selection: the embedded repurchase option prevents the market unraveling that occurs in asset-sale markets. However, the contract is inefficient due to cream skimming. Competition to attract high-quality borrowers through the terms of the repurchase option inefficiently lowers liquidity. The equilibrium contract has a closed form and is portable to many applications.
Keywords: Repurchase Agreement, Collateralized Debt, Private Information, Optimal Contracts
JEL Classification: D82, G23, G32
Suggested Citation: Suggested Citation