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The Opportunity Cost of Collateral

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  • Jason Donaldson

    (Washington University in St Louis)

  • Giorgia Piacentino

    (Columbia University)

  • Jeongmin Lee

    (Washington University in St. Louis)

Abstract

We present a dynamic model of the repo market in which the liquidity of collateral determines the opportunity cost of lending. Because illiquid collateral is hard to convert to cash to undertake investment opportunities, the opportunity cost of lending against it is high. Hence spreads are high on repos backed by illiquid collateral, even if default risk is not. This opportunity cost channel leads to a new amplification mechanism: a decrease in the liquidity of collateral increases the opportunity cost of capital, contracting credit and depressing asset prices. The option to buy assets at depressed prices spirals back to increase the opportunity cost further, causing a repo run. We solve for the model dynamics following a negative shock to the liquidity of collateral and use the model to assess how much the opportunity cost channel contributed to repo runs in the 2008-2009 crisis.

Suggested Citation

  • Jason Donaldson & Giorgia Piacentino & Jeongmin Lee, 2018. "The Opportunity Cost of Collateral," 2018 Meeting Papers 1180, Society for Economic Dynamics.
    • Handle: RePEc:red:sed018:1180
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    Cited by:

    1. Gabrovski, Miroslav & Ortego-Marti, Victor, 2021. "Search and credit frictions in the housing market," European Economic Review, Elsevier, vol. 134(C).
    2. Donaldson, Jason & Piacentino, Giorgia, 2019. "Money Runs," CEPR Discussion Papers 13955, C.E.P.R. Discussion Papers.
    3. Donaldson, Jason Roderick & Piacentino, Giorgia, 2022. "Money runs," Journal of Monetary Economics, Elsevier, vol. 126(C), pages 35-57.

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