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Liquid Bundles

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  • Emmanuel Farhi
  • Jean Tirole

Abstract

The paper revisits and qualifies existing insights on security design. A rich literature argues that tranching creates debt-like instruments that are robust to adverse selection or discourage wasteful information acquisition. Yet, for a given information structure, while tranching confines and liquefies the safe part of a cash flow (the insulation effect), bundling makes the risky part more liquid (the trading adjuvant effect). Moreover, tranching always has adverse welfare effects on information acquisition: It encourages (discourages) information acquisition when it should be deterred (encouraged). The paper provides conditions under which tranching reduces welfare even when the insulation effect dominates the trading adjuvant effect. The paper's second contribution is to analyze the velocity of assets that are repeatedly traded. The dynamic model can be nested into the static one and insights are shown to be closely related to those on tranching. The central insight is that liquidity is self-fulfilling: A perception of future illiquidity creates current illiquidity.

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Bibliographic Info

Paper provided by Harvard University OpenScholar in its series Working Paper with number 70971.

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Date of creation: Jan 2012
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Handle: RePEc:qsh:wpaper:70971

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  1. Peter DeMarzo & Darrell Duffie, 1999. "A Liquidity-Based Model of Security Design," Econometrica, Econometric Society, Econometric Society, vol. 67(1), pages 65-100, January.
  2. Leland, Hayne E & Pyle, David H, 1977. "Informational Asymmetries, Financial Structure, and Financial Intermediation," Journal of Finance, American Finance Association, American Finance Association, vol. 32(2), pages 371-87, May.
  3. Stewart C. Myers & Nicholas S. Majluf, 1984. "Corporate Financing and Investment Decisions When Firms Have InformationThat Investors Do Not Have," NBER Working Papers 1396, National Bureau of Economic Research, Inc.
  4. Benjamin Lester & Andrew Postlewaite & Randall Wright, 2008. "Information, Liquidity and Asset Prices," PIER Working Paper Archive 08-039, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
  5. Gary Gorton & Guillermo Ordonez, 2011. "Collateral Crises," IMES Discussion Paper Series 11-E-25, Institute for Monetary and Economic Studies, Bank of Japan.
  6. Whinston, Michael D, 1990. "Tying, Foreclosure, and Exclusion," American Economic Review, American Economic Association, American Economic Association, vol. 80(4), pages 837-59, September.
  7. Myers, Stewart C. & Majluf, Nicolás S., 1945-, 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Working papers, Massachusetts Institute of Technology (MIT), Sloan School of Management 1523-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  8. repec:bla:restud:v:76:y:2009:i:1:p:395-412 is not listed on IDEAS
  9. Myers, Stewart C. & Majluf, Nicholas S., 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Journal of Financial Economics, Elsevier, Elsevier, vol. 13(2), pages 187-221, June.
  10. Guillaume Plantin, 2009. "Learning by Holding and Liquidity," Review of Economic Studies, Oxford University Press, vol. 76(1), pages 395-412.
  11. Subrahmanyam, Avanidhar, 1991. "A Theory of Trading in Stock Index Futures," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 4(1), pages 17-51.
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