Working Paper: NBER ID: w27732
Authors: Saki Bigio; Liyan Shi
Abstract: We study repurchase options (repo contracts) in a competitive asset market with asymmetric information. Gains from trade emerge from a liquidity need, but private information about asset quality prevents the full realization of trade. We obtain a unique equilibrium, which features a pooling repo contract and full participation among borrowers. The equilibrium repo contract resolves adverse selection: the embedded repurchase option prevents the market unraveling that occurs in asset-sale markets. However, the contract is inefficient due to cream skimming. Competition to attract high-quality borrowers through the terms of the repurchase option inefficiently lowers liquidity. The equilibrium contract has a closed form and is portable to many applications.
Keywords: repurchase options; adverse selection; market liquidity; investment funding
JEL Codes: D82; G23; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Repo contracts (D86) | resolve adverse selection (D82) |
| Repo contracts (D86) | allow good borrowers to participate in the market (G21) |
| Good borrowers (G51) | accept repo contracts (L14) |
| Repo contracts (D86) | prevent market unraveling (E44) |
| Competition among lenders (G21) | cream skimming (D49) |
| Cream skimming (D49) | reduce overall liquidity (E41) |
| Repo contracts (D86) | increase market participation (D40) |
| Repo contracts (D86) | enhance funding for investment projects (H54) |