Working Paper: NBER ID: w16777
Authors: Nicolae Grleanu; Lasse Heje Pedersen
Abstract: In a model with heterogeneous-risk-aversion agents facing margin constraints, we show how securities' required returns are characterized both by their betas and their margin requirements. Negative shocks to fundamentals make margin constraints bind, lowering risk-free rates and raising Sharpe ratios of risky securities, especially for high-margin securities. Such a funding-liquidity crisis gives rise to "bases," that is, price gaps between securities with identical cash-flows but different margins. In the time series, bases depend on the shadow cost of capital, which can be captured through the interest-rate spread between collateralized and uncollateralized loans, and, in the cross section, they depend on relative margins. We test the model empirically using the CDS-bond bases and other deviations from the Law of One Price, and use it to evaluate central banks' lending facilities.
Keywords: Margin Requirements; Asset Pricing; Liquidity Crises; Law of One Price
JEL Codes: E02; E44; G01; G12; G13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| interest rate differential (E43) | funding constraints (H60) |
| funding constraints (H60) | asset pricing effects (G19) |
| margin requirements (G32) | required returns on securities (G12) |
| negative shocks to fundamentals (F69) | margin constraints (D43) |
| margin constraints (D43) | lower risk-free rates (G19) |
| margin constraints (D43) | higher Sharpe ratios for risky securities (G12) |
| higher margin requirements (G21) | larger betas and volatilities during crises (G01) |
| lower margin requirements during liquidity crises (E44) | increased asset prices (G19) |
| margin requirements (G32) | differences in basis (price gap) between securities (G12) |
| tightness of credit standards (G21) | relationship with CDS-bond basis (G12) |