Secondary Market Liquidity and the Optimal Capital Structure

Posted: 9 Jul 2021

See all articles by David M. Arseneau

David M. Arseneau

Board of Governors of the Federal Reserve System

David E. Rappoport

affiliation not provided to SSRN

Alexandros Vardoulakis

Board of Governors of the Federal Reserve System

Multiple version iconThere are 3 versions of this paper

Date Written: May, 2015

Abstract

We present a model where endogenous liquidity generates a feedback loop between secondary market liquidity and firms' financing decisions in primary markets. The model features two key frictions: a costly state verification problem in primary markets, and search frictions in over-the-counter secondary markets. Our concept of liquidity depends endogenously on illiquid assets put up for sale relative to the resources available for buying those assets in the secondary market. Liquidity determines the liquidity premium, which affects issuance in the primary market, and this effect feeds back into secondary market liquidity by changing the composition of investors' portfolios. We show that the privately optimal allocations are inefficient because investors and firms fail to internalize how their behavior affects secondary market liquidity. These inefficiencies are established analytically through a set of wedge expressions for key efficiency margins. Our analysis provide s a rationale for the effect of quantitative easing on secondary and primary capital markets and the real economy.

JEL Classification: E44, G18, G30

Suggested Citation

Arseneau, David M. and Rappoport, David E. and Vardoulakis, Alexandros, Secondary Market Liquidity and the Optimal Capital Structure (May, 2015). FEDS Working Paper No. 2015-31, Available at SSRN: https://ssrn.com/abstract=3879397

David M. Arseneau (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

David E. Rappoport

affiliation not provided to SSRN

No Address Available

Alexandros Vardoulakis

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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