Secondary market liquidity and security design: theory and evidence from ABS markets

Friewald, N, Hennessy, C A and Jankowitsch, R (2015) Secondary market liquidity and security design: theory and evidence from ABS markets. Working Paper. London Business School Working Paper.

Abstract

We develop a theory of primary market discounts demanded by ex ante identical strategic uninformed investors facing heterogeneous carrying costs realizations. Such investors demand primary market discounts equaling expected secondary market trading losses plus carrying costs. Security design is shown to complement strategic trading ability, as repackaging cash flow gives uninformed investors flexible exit options. Issuers minimize discounts by splitting cash flow into tranched debt claims, with secondary market liquidity increasing in seniority. The optimal number of tranches increases with cash flow informationsensitivity and decreases with carrying costs. Deadweight loss is socially excessive due to excessively thin tranches. Consistent with the model, empirical tests confirm ABS trading costs decrease and trading volume increases with seniority, while the number of tranches increases with informationsensitivity.