Collateral Risk, Information Sensitivity, and Default Frictions on Collateralized Debt

Abstract

We develop a theory of collateralized debt that emphasizes collateral risk, incentives to acquire information about collateral, and opportunistic default to study the determinants of the loan size, interest rates, and haircuts. The model predicts that safe assets are traded without haircuts and that risky collateral tends to be associated with higher interest rates and haircuts and with smaller loan sizes. When both interest rates and haircuts exist, there is a substitution effect between interest rates and haircuts, keeping all other factors constant. The model also provides new perspectives on the effects of an increase in collateral risk.

Keywords: Collateralized debt, Collateral risk, Costly information acquisition, Opportunistic default, Repos