Topic：Optimal Debt Financing and the Pricing of Illiquid Assets

Speaker: Antonio Bernardo

Affiliation: UCLA Anderson School of Management

Time：3:30-5:00pm, November 16

Location：Room B35, Guanghua New Building

Paper: Download PDF

Abstract: We develop a model in which the equilibrium returns of illiquid assets are determined by the debt capacity of arbitrageurs rather than the desire to smooth consumption shocks. Debt allows risk-neutral arbitrageurs to earn a spread between an asset’s expected cash flow and its equilibrium price, but increases the likelihood they will be forced to liquidate the asset at a discount to its fundamental value. We show that the costs of debt are convex, implying finite aggregate debt capacity among the arbitrageurs. If arbitrageurs have limited access to equity capital, these debt costs impose a “limit to arbitrage” and illiquid assets earn a return premium in equilibrium even though the arbitrageurs are risk neutral. If we introduce assets with independent fundamentals, arbitrageurs optimally take on more debt and the return premium declines because the probability of early liquidation is reduced through diversification. Although fundamentals are independent, assets exhibit commonality in liquidity and state-dependent return correlations when the likelihood of forced liquidation is correlated across arbitrageurs.