Secured Lending and Asset Prices

Personal bankruptcy makes ...nancial contracts hard to enforce puts because it weakens the punishment technologies available to creditors. I consider a generic endowment economy in which agents trade a complete set of contingent claims. As in Alvarez and Jermann (2000), these contracts are not enforceable. In this model, when households default, they cannot be excluded from ...nancial markets but they lose all of the collateral. The value of an agent’s outside option is determined endogenously as the continuation value of starting over without collateral. To compute the equilibrium, this economy is mapped into an equivalent economy which uses promised utilities as a record keeping device (APS, 1986). In equilibrium all lending is fully collateralized. The collateral constraints introduce another dimension of risk re‡ected in asset prices: covariation with the constraints. The economy’s ability to bear risk is driven by variation in the average agent’s collateral constraints in addition to variation in her marginal utility. Assets which o¤er a high return when this agent is severely constrained provide a hedge and earn a low excess return. In addition, assets which cannot be collateralized trade at a discount.