Repurchase Options in the Market for Lemons

50 Pages Posted: 25 Aug 2020

See all articles by Saki Bigio

Saki Bigio

University of California, Los Angeles (UCLA) - Department of Economics

LIYAN SHI

Einaudi Institute for Economics and Finance

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Date Written: August 2020

Abstract

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.

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Suggested Citation

Bigio, Saki and SHI, LIYAN, Repurchase Options in the Market for Lemons (August 2020). NBER Working Paper No. w27732, Available at SSRN: https://ssrn.com/abstract=3679725

Saki Bigio (Contact Author)

University of California, Los Angeles (UCLA) - Department of Economics ( email )

8283 Bunche Hall
Los Angeles, CA 90095-1477
United States

LIYAN SHI

Einaudi Institute for Economics and Finance ( email )

Via Due Macelli, 73
Rome, 00187
Italy

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