Rollover Risk and Market Freezes

Viral V. Acharya (), Douglas Gale () and Tanju Yorulmazer ()

No 7122, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: We consider the debt capacity of a risky asset when debt is being rolled over and there is a liquidation cost in case of default. We show that debt capacity depends on how information about the quality of the asset is revealed. When the information structure is based on “optimistic” expectations, the arrival of no news about the asset is good news; under this structure, debt capacity does not depend upon rollovers and liquidation cost, and is simply equal to expected cash flows from the asset. In contrast, when the information structure is based on “pessimistic” expectations, no news about the asset is bad news; under this structure, debt capacity of the asset is decreasing in the liquidation cost and frequency of rollovers. In the limit, as the number of rollovers becomes unbounded, the debt capacity goes to zero even for an arbitrarily small default risk. Our model explains why markets for rollover debt, such as asset-backed commercial paper, may experience sudden freezes. The model also provides an explicit formula for the haircut in secured borrowing or repo transactions.

Keywords: asset-backed commercial paper; credit risk; haircut; liquidation cost; repo; secured borrowing (search for similar items in EconPapers)
JEL-codes: D8 G12 G21 G24 G32 G33 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-fmk
Date: 2009-01
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