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Margin-Based Asset Pricing and Deviations from the Law of One Price

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  • Nicolae Garleanu

    (University of California at Berkeley, NBER, and CEPR)

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    Abstract

    In a model with multiple agents with different risk aversions facing margin constraints, we show how securities’ required returns are characterized both by their beta and their margins. 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 a “basis,” that is, a price gap between securities with identical cash-flows but different margins. In the time series, the basis depends 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, it depends on relative margins. We apply the model empirically to the CDS-bond basis and other deviations from the Law of One Price, and to evaluate the effects of unconventional monetary policy and lending facilities.

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    Bibliographic Info

    Paper provided by Society for Economic Dynamics in its series 2010 Meeting Papers with number 1323.

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    Date of creation: 2010
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    Handle: RePEc:red:sed010:1323

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    Cited by:
    1. Robin Greenwood & Samuel G. Hanson, 2011. "Issuer Quality and the Credit Cycle," NBER Working Papers 17197, National Bureau of Economic Research, Inc.

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