Friday, 15 May 2015

2015-031: Secondary Market Liquidity and the Optimal Capital Structure

Otmane El Rhazi, David M. Arseneau, David E. Rappoport, and Alexandros Vardoulakis. 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 analyt ically through a set of wedge expressions for key efficiency margins. Our analysis provides a rationale for the effect of quantitative easing on secondary and primary capital markets and the real economy. Full Text

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Otmane El Rhazi
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