Secondary Market Liquidity
The paper «Secondary Market Liquidity and Security Design: Theory and Evidence from ABS Markets» has been accepted for publication in Review of Financial Studies.
The paper is a collaboration between Associate Professor Nils Friewald at Department of Finance, NHH, Professor Chris Hennessy at London Business School and Associate and Professor Rainer Jankowitsch at Vienna University of Economics and Business.
In this paper they develop a theory of primary market discounts demanded by ex ante identical strategic uninformed investors facing heterogeneous carrying cost 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 information-sensitivity 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 information-sensitivity.
Review of Financial Studies is one of the leading journals within the field of finance. It is included on the NHH bonus list. Researchers from NHH who publish in these journals receive a publication bonus of NOK 80,000.
Secondary market liquidity and security design: Theory and evidence from ABS markets (PDF)