Working Paper | HBS Working Paper Series | 2010

Crashes and Collateralized Lending

by Jakub W. Jurek and Erik Stafford

Abstract

This paper develops a parsimonious static model for characterizing financing terms in collateralized lending markets. We characterize the systematic risk exposures for a variety of securities and develop a simple indifference-pricing framework to value the systematic crash risk exposure of the collateral. We then apply Modigliani and Miller's (1958) Proposition Two (MM) to split the cost of bearing this risk between the borrower and lender, resulting in a schedule of haircuts and financing rates. The model produces comparative statics and time-series dynamics that are consistent with the empirical features of repo market data, including the credit crisis of 2007-2008.

Keywords: Financial Crisis; Borrowing and Debt; Cost of Capital; Credit; Financing and Loans; Interest Rates; Investment; Framework; Risk and Uncertainty; Financial Services Industry;

Citation:

Jurek, Jakub W., and Erik Stafford. "Crashes and Collateralized Lending." Harvard Business School Working Paper, No. 11-025, September 2010.