Securities market theory: Possession, repo and rehypothecation

By introducing repo markets we understand how agents need to borrow issued securities before shorting them: (re)-hypothecation is at the heart of shorting. Non-negative amounts of securities in the box of an agent (amounts borrowed or owned but not lent on) can be sold, and recursive use of securities as collateral allows agents to leverage their positions. A binding box constraint induces a liquidity premium: the repo rate becomes special and the security price higher than expected discounted cash-flows. Existence of equilibrium is guaranteed under limited re-hypothecation, a situation secured by (current or proposed) institutional arrangements. © 2011 Elsevier Inc. All rights reserved. JEL classification: D52; D53; G12