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Repurchase Options in the Market for Lemons

Saki Bigio and Liyan Shi
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Liyan Shi: EIEF

No 2104, EIEF Working Papers Series from Einaudi Institute for Economics and Finance (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.

Pages: 49 pages
Date: 2021, Revised 2021
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Working Paper: Repurchase Options in the Market for Lemons (2020) Downloads
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