Secondary Market Liquidity and Security Design: Theory and Evidence from ABS Markets

Friewald, N, Hennessy, C and Jankowitsch, R (2016) Secondary Market Liquidity and Security Design: Theory and Evidence from ABS Markets. Review of Financial Studies, 29 (5). pp. 1254-1290. ISSN 0893-9454 OPEN ACCESS

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.

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Item Type: Article
Subject Areas: Finance
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© 2015 Oxford University Press

Date Deposited: 18 Nov 2016 14:14
Date of first compliant deposit: 11 Feb 2020
Subjects: Pricing
Investment funds
Last Modified: 21 Nov 2024 02:35
URI: https://lbsresearch.london.edu/id/eprint/614
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