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Secondary Market Liquidity and the Optimal Capital Structure

David Arseneau, David E. Rappoport and Alexandros Vardoulakis
Additional contact information
David E. Rappoport: https://www.federalreserve.gov/econres/david-e-rappoport.htm
Alexandros Vardoulakis: https://www.federalreserve.gov/econres/alexandros-vardoulakis.htm

No 2015-31, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

Abstract: We present a model where endogenous liquidity generates a feedback loop between secondary market liquidity and firms' financing decisions in primary markets. The model features two key frictions: a costly state verification problem in primary markets, and search frictions in over-the-counter secondary markets. Our concept of liquidity depends endogenously on illiquid assets put up for sale relative to the resources available for buying those assets in the secondary market. Liquidity determines the liquidity premium, which affects issuance in the primary market, and this effect feeds back into secondary market liquidity by changing the composition of investors' portfolios. We show that the privately optimal allocations are inefficient because investors and firms fail to internalize how their behavior affects secondary market liquidity. These inefficiencies are established analytically through a set of wedge expressions for key efficiency margins. Our analysis provide s a rationale for the effect of quantitative easing on secondary and primary capital markets and the real economy.

Keywords: Capital structure; market liquidity; quantitative easing; secondary markets (search for similar items in EconPapers)
JEL-codes: E44 G18 G30 (search for similar items in EconPapers)
Pages: 68 pages
Date: 2015-05-12
New Economics Papers: this item is included in nep-dge, nep-fmk and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

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http://www.federalreserve.gov/econresdata/feds/2015/files/2015031pap.pdf Full text (application/pdf)
http://dx.doi.org/10.17016/FEDS.2015.031 http://dx.doi.org/10.17016/FEDS.2015.031 (application/pdf)

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