There is a large literature, starting with Jensen & Meckling (1976), discussing how agency conflicts affect a firm's capital structure decisions. Evidence from early work generally indicates that entrenched managers prefer lower leverage (Berger, Ofek & Yermack (1997), Garvey & Hanka (1999)). In recent years, widely available use of indices to measure shareholder rights (for example, the Gin dex of Gompers, Ishii & Metrick (2003)) has produced new results that do not agree with these empirical findings.
World capital markets have experienced large?scale sovereign defaults on a number of occasions, the most recent being Argentina?s default in 2002. This latest crisis is the fifth Argentine default or restructuring episode in the last 180 years. While Argentina may be an extreme case, sovereign defaults occur with some frequency in emerging markets.
A second set of facts about emerging markets relates to the behavior of the interest rates at which these economies borrow from the rest of the world and their current accounts. Interest rates and the current account are strongly counter cyclical and positively correlated with each other. That is, emerging markets tend to borrow more in good times and at lower interest rates than in slumps. These features contrast with those observed in developed small open economies.
The relation between liquidity and asset prices has received considerable attention recently. However, much less is known about liquidity effects in derivative markets. This paper provides a theoretical model of liquidity effects in derivative markets and estimates this model for the credit default swap market. Recent market developments suggest that the credit default swap (CDS) market is subject to shocks in liquidity. In the subprime crisis of summer 2007, not only credit spreads increased substantially, but liquidity also dropped dramatically.
Our paper makes three contributions. Our first contribution is a theoretical asset pricing model for derivatives that incorporates liquidity risk. This model extends the ‘Liquidity-CAPM’ of Acharya and Pedersen (2005), who only consider investors with long positions in assets that are in positive net supply, in which case illiquidity always leads to lower asset prices. For derivative securities, which are in zero net supply, the effect of liquidity is much more complicated and can be zero, positive or negative. We propose an equilibrium framework where heterogenous investors use derivatives to hedge a fixed (credit) risk exposure. Transaction costs for derivatives vary systematically over time. We derive that under fairly mild conditions, the expected return on the derivative asset can be decomposed into market risk premia, an expected liquidity component, and one liquidity risk premium. This result differs from the result for a positive net supply market as in Acharya and Pedersen (2005) where there are three liquidity risk premia. In particular, our model predicts that the liquidity exposure of a derivative to derivative-market liquidity is not priced. We show that sign of the liquidity effects depends on heterogeneity in investors’ risk exposures, risk aversion and wealth. Our model is related to work on hedging pressures in futures markets (De Roon, Nijman and Veld, 2000) and option markets (Garleanu, Pedersen and Poteshman, 2006).
