Price Formation of Pledgeable Securities
Extant literature on the pricing of pledgeable securities focuses on models of risk sharing. I derive the equilibrium price function in rational expectations when investors have heterogeneous information. That allows me to focus on the implications pledgeability has for informational efficiency. The linear price function is unique and shows the impact of participation and margin policies on price formation, in a market where transactions are cleared through a central counterparty. The two legs of collateralized loans, such as repurchase agreements, blur incentives of rational traders when the repo margin is sufficiently low: since buyers of securities are at the same time suppliers in the repo market at the initial date, investors' optimal decision detaches the spot price of pledgeable securities from their fundamental value. A similar nding is considered to be a premium in models of risk sharing. I show that pledgeability hurts informational efficiency as it increases the conditional variance of the price function. The use of Risk Neutral Valuation allows to find an analytic solution to the equilibrium price, whereas extant literature relies on numerical approximation. The impact of pledgeability contributes to explain asset prices comovement and seemingly violations of the law of one price.
BEMPS - Bozen Economics & Management Paper Series, No. 26/2015