Seminar

Margin-Based Asset Pricing and Deviations from the Law of One Price

Nicolae Garleanu (Berkeley)

October 12, 2009, 12:30–14:00

Room MF 323

Fédération des Banques Françaises Seminar

Abstract

In a model with heterogeneous-risk-aversion agents facing margin constraints, we show how securities’ required returns are characterized both by their betas and their margins. Negative shocks to fundamentals make margin constraints bind, lowering risk-free rates and raising Sharpe ratios of risky securities, especially for high-margin securities. Such a funding liquidity crisis gives rise to “bases,” that is, price gaps between securities with identical cash-flows but different margins. In the time series, bases depend on the shadow cost of capital, which can be captured through the interest- rate spread between collateralized and uncollateralized loans, and, in the cross section, they depend on relative margins. We apply the model empirically to CDS-bond bases and other deviations from the Law of One Price, and to evaluate the Fed lending facilities.