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Repurchase Options in the Market for Lemons

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  • Saki Bigio

    (UCLA)

  • Liyan Shi

    (EIEF)

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.

Suggested Citation

  • Saki Bigio & Liyan Shi, 2021. "Repurchase Options in the Market for Lemons," EIEF Working Papers Series 2104, Einaudi Institute for Economics and Finance (EIEF), revised 2021.
    • Handle: RePEc:eie:wpaper:2104
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    Cited by:

    1. Emre Ozdenoren & Kathy Yuan & Shengxing Zhang, 2023. "Dynamic Asset-Backed Security Design," Review of Economic Studies, Oxford University Press, vol. 90(6), pages 3282-3314.
    2. Emre Ozdenoren & Kathy Yuan & Shengxing Zhang, 2023. "Dynamic Asset-Backed Security Design," Review of Economic Studies, Oxford University Press, vol. 90(6), pages 3282-3314.

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    More about this item

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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