Portfolio Choice and Settlement Frictions: A Theory of Endogenous Convenience Yields

Javier Bianchi and Saki Bigio

No 812, Working Papers from Federal Reserve Bank of Minneapolis

Abstract: We study settlement frictions that arise from the need to finance negative balances through an over-the-counter (OTC) market. We derive a closed-form expression for the endogenous convenience yield and show how it can be incorporated into a canonical portfolio problem. Using this framework, we examine how shifts in settlement frictions affect liquidity premia, the volume of overnight funding, the dispersion of market rates, and optimal portfolio allocations. From a normative perspective, we show that in the competitive equilibrium, investors may either over- or under-invest in liquid assets; moreover, both higher risk aversion and tighter aggregate liquidity increase the likelihood of under-accumulation.

Keywords: OTC markets; Convenience yields; Portfolio theory; Asset pricing (search for similar items in EconPapers)
JEL-codes: E51 E52 E58 G12 G21 (search for similar items in EconPapers)
Date: 2025-11-19
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Working Paper: Portfolio Choice and Settlement Frictions: A Theory of Endogenous Convenience Yields (2025)
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedmwp:102152

DOI: 10.21034/wp.812

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