Collateralizing Liquidity

Abstract

I develop a dynamic model of optimal funding to understand why liquid financial assets are used as collateral instead of being sold to raise funds. Firms need funds to invest in risky projects with non-verifiable returns. Since holding these assets allows firms to raise these funds, firms with investment opportunities value the asset more than those without them. When investment opportunities are persistent, borrowers value the asset as a future funding source and optimally use liquid financial assets as collateral. Assets carry (funding) liquidity and collateral premia. As market liquidity increases, the liquidity premium increases while the collateral premium decreases.