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Secondary Market Liquidity and the Optimal Capital Structure

Author

Listed:
  • David Rappoport

    (Federal Reserve Board)

  • Alexandros Vardoulakis

    (Board of Governors of the Federal Reserve System)

  • David Arseneau

    (Federal Reserve Board)

Abstract

We present a model to study the feedback loop between secondary market liquidity and firm's 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 liquidity concept depends on the endogenous holdings of assets put for sale relative to the resources available for buying illiquid assets. This creates a feedback loop as issuance in primary markets affects secondary market liquidity, and vice versa through liquidity premia. We show that the privately optimal allocations are inefficient. Both investors and firms can be made better off if firms take on lower leverage and less risk, and investors provide more liquidity. These inefficiencies are established analytically 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.

Suggested Citation

  • David Rappoport & Alexandros Vardoulakis & David Arseneau, 2015. "Secondary Market Liquidity and the Optimal Capital Structure," 2015 Meeting Papers 1274, Society for Economic Dynamics.
    • Handle: RePEc:red:sed015:1274
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    References listed on IDEAS

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    Cited by:

    1. Athanasios Geromichalos & Lucas Herrenbrueck & Sukjoon Lee, 2023. "The Strategic Determination of the Supply of Liquid Assets," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 49, pages 1-36, July.
    2. Gazi I. Kara & S. Mehmet Ozsoy, 2016. "Bank regulation under fire sale externalities," Finance and Economics Discussion Series 2016-026, Board of Governors of the Federal Reserve System (U.S.).
    3. Geromichalos, Athanasios & Herrenbrueck, Lucas, 2016. "The Strategic Determination of the Supply of Liquid Assets," MPRA Paper 71454, University Library of Munich, Germany.
    4. Gazi I Kara & S Mehmet Ozsoy & Itay Goldstein, 2020. "Bank Regulation under Fire Sale Externalities," The Review of Financial Studies, Society for Financial Studies, vol. 33(6), pages 2554-2584.
    5. Zachary Bethune & Bruno Sultanum & Nicholas Trachter, 2019. "Asset Issuance in Over-the-Counter Markets," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 33, pages 4-29, July.
    6. Athanasios Geromichalos & Lucas Herrenbrueck & Sukjoon Lee, 2023. "The Strategic Determination of the Supply of Liquid Assets," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 49, pages 1-36, July.

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    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G30 - Financial Economics - - Corporate Finance and Governance - - - General

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