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

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  • Nils Friewald
  • Christopher A. Hennessy
  • Rainer Jankowitsch

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. Received November 7, 2013; accepted November 14, 2015 by Editor Itay Goldstein.

Suggested Citation

  • Nils Friewald & Christopher A. Hennessy & Rainer Jankowitsch, 2016. "Secondary Market Liquidity and Security Design: Theory and Evidence from ABS Markets," The Review of Financial Studies, Society for Financial Studies, vol. 29(5), pages 1254-1290.
    • Handle: RePEc:oup:rfinst:v:29:y:2016:i:5:p:1254-1290.
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    File URL: http://hdl.handle.net/10.1093/rfs/hhv128
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    Cited by:

    1. Huh, Yesol & Kim, You Suk, 2023. "Cheapest-to-deliver pricing, optimal MBS securitization, and welfare implications," Journal of Financial Economics, Elsevier, vol. 150(1), pages 68-93.
    2. Taneli Mäkinen & Francesco Palazzo, 2017. "The double bind of asymmetric information in over-the-counter markets," Temi di discussione (Economic working papers) 1128, Bank of Italy, Economic Research and International Relations Area.
    3. Babus, Ana & Hachem, Kinda, 2023. "Markets for financial innovation," Journal of Economic Theory, Elsevier, vol. 208(C).
    4. Chao Ma & Hao Zhang & Hongbiao Zhao, 2023. "Securitization of assets with payment delay risk: A financial innovation in the real estate market," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 43(4), pages 480-515, April.
    5. Efraim Benmelech & Nittai Bergman, 2018. "Debt, Information, and Illiquidity," NBER Working Papers 25054, National Bureau of Economic Research, Inc.
    6. Li, Qi, 2022. "Security design without verifiable retention," Journal of Economic Theory, Elsevier, vol. 200(C).
    7. Yesol Huh & You Suk Kim, 2021. "Cheapest-to-Deliver Pricing, Optimal MBS Securitization, and Market Quality," Finance and Economics Discussion Series 2021-031, Board of Governors of the Federal Reserve System (U.S.).

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