Secondary market liquidity and security design: theory and evidence from ABS markets
Journal
Review of Financial Studies
Subject
Finance
Publishing details
Authors / Editors
Friewald N;Hennessy C;Jankowitsch R
Biographies
Publication Year
2016
Abstract
We develop and empirically test a theory of optimal security design under adverse selection accounting for strategic trading by uninformed investors who will liquidate a security in secondary markets only if their idiosyncratic carrying costs exceed the security's expected trading loss. Such investors demand primary market discounts equaling expected carrying costs borne plus trading losses incurred. Issuers minimize the total illiquidity discount by splitting cash-flow into tranched debt claims with liquidity predicted to increase with seniority, while the optimal number of tranches increases with underlying cash-flow risk. Empirical tests confirm our model predictions.
Available on ECCH
No
