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Collateralized Borrowing and Increasing Risk

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Abstract

This paper uses a general equilibrium model with collateralized borrowing to show that increases in risk can have ambiguous effects on leverage, loan margins, loan amounts, and asset prices. Increasing risk about future payoffs and endowments can lead to riskier loans with larger balances and lower spreads even when lenders are risk-averse and borrowers can default. As well, increasing the covariance of either agents' endowments with the asset payoff can have ambiguous consequences for equilibrium. Though the effects are ambiguous, key determinants of how increased risk translate into changes in prices and allocations are the correlation of agents' endowments with the asset payoff, agents' risk aversion, and the location of increased risk in the distribution of future states. Some restricted changes in the borrower's or lender's endowments can have unambiguous but asymmetric effects on equilibrium.

Suggested Citation

  • Gregory Phelan, 2015. "Collateralized Borrowing and Increasing Risk," Department of Economics Working Papers 2015-03, Department of Economics, Williams College, revised Jun 2015.
    • Handle: RePEc:wil:wileco:2015-03
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    Cited by:

    1. Hoelle, Matthew, 2017. "The effects of dependent beliefs on endogenous leverage," Journal of Mathematical Economics, Elsevier, vol. 73(C), pages 68-80.
    2. Feixue Gong & Gregory Phelan, 2020. "Debt collateralization, capital structure, and maximal leverage," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 70(2), pages 579-605, September.
    3. Feixue Gong & Gregory Phelan, 2016. "Debt Collateralization, Structured Finance, and the CDS Basis," Department of Economics Working Papers 2016-06, Department of Economics, Williams College, revised Aug 2017.
    4. Yuchi Chu & Yiting Li, 2024. "Secured Loans and Risky Assets in a Monetary Economy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 56(2-3), pages 395-427, March.
    5. Feixue Gong & Gregory Phelan, 2023. "Collateral constraints, tranching, and price bases," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 75(2), pages 317-340, February.
    6. Zehao Liu & Chengbo Xie, 2023. "Haircuts, interest rates, and credit cycles," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 76(1), pages 69-109, July.

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    Keywords

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    JEL classification:

    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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