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Secondary Market Liquidity and the Optimal Capital Structure

David Rappoport, Alexandros Vardoulakis and David Arseneau
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David Rappoport: Federal Reserve Board
Alexandros Vardoulakis: Board of Governors of the Federal Reserve System

No 1274, 2015 Meeting Papers from Society for Economic Dynamics

Abstract: We present a model to study the feedback loop between secondary market liquidity and firm's 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 liquidity concept depends on the endogenous holdings of assets put for sale relative to the resources available for buying illiquid assets. This creates a feedback loop as issuance in primary markets affects secondary market liquidity, and vice versa through liquidity premia. We show that the privately optimal allocations are inefficient. Both investors and firms can be made better off if firms take on lower leverage and less risk, and investors provide more liquidity. These inefficiencies are established analytically through a set of wedge expressions for key efficiency margins. Our analysis provides a rationale for the effect of quantitative easing on secondary and primary capital markets and the real economy.

Date: 2015
New Economics Papers: this item is included in nep-dge and nep-mac
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Citations: View citations in EconPapers (8)

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