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Illiquid securities carry higher risks than liquid ones, which becomes especially true during times of market turmoil when the ratio of buyers to sellers may be thrown out of balance.During these times, holders of illiquid securities may find themselves unable to unload them at all, or unable to do so without losing a lot of money.Keywords: Collateral; Liquidation; Repo market; Illiquidity; Fire sales; Creditor structure; Counterparty risk management (search for similar items in Econ Papers) JEL-codes: G00 G20 G32 G33 (search for similar items in Econ Papers) Date: 2014 References: View references in Econ Papers View complete reference list from Cit Ec Citations View citations in Econ Papers (4) Track citations by RSS feed Downloads: (external link) Full text for Science Direct subscribers only Related works: This item may be available elsewhere in Econ Papers: Search for items with the same title.Export reference: Persistent link: https://Econ Papers.repec.org/Re PEc:eee:jetheo:v:149:y:2014:i:c:p:183-210 Access Statistics for this article Journal of Economic Theory is currently edited by A. Assets that pose material credit and/or liquidity risks can be used as collateral but not for their full market value.
Instead, the collateral value of the asset is usually set below its market value in order to take account of potential price volatility between margin calls, the probable high cost of liquidation in the event of a default and other risks).
An asset's liquidity may change over time, depending on outside market influences.
This is especially true for collectibles, as an item's popularity in the consumer market may fluctuate dramatically, leading to highly volatile pricing.
I show that: (i) the equilibrium price of the collateral asset overshoots during liquidation when the prime brokers are sufficiently balance-sheet constrained; (ii) spreading a collateral position across multiple prime brokers alleviates balance sheet constraints, but can cause inefficient ‘racing to the market’, potentially reducing expected liquidation proceeds; (iii) prime brokers should take into account a hedge fund’s creditor structure and their own balance sheet constraints when setting margins to manage counterparty risk; (iv) the model pins down the block price and expected profit at which a ‘deep pocket’ buyer can purchase the entire collateral position.
The model shows that (i) the equilibrium price of the collateral asset can overshoot; (ii) the creditor structure in repo lending involves a fundamental trade-off between risk sharing and inefficient “rushing for the exits” by competing sellers of collateral; (iii) repo lenders should take into account creditor structure, strategic interaction, and their own balance sheet constraints when setting margins; and (iv) the model provides a framework to analyze transfers of repo collateral to “deep-pocket” buyers or a repo resolution authority. I am particularly grateful to my advisor, Markus Brunnermeier, as well as José Scheinkman and Hyun Shin.
Certain collectibles and art pieces may be considered illiquid assets as well.