Debt Financing in Asset Markets

The widely used short-term debt such as overnight repos and commercial paper is regarded as one of the main sources of instability leading to the distress of many …nancial institutions during the …nancial crisis of 2007-2008. What explains the popularity of shortterm debt in …nancing asset market investments? Geanakoplos (2010) presents a dynamic model of the joint equilibrium of asset markets and credit markets, in which optimistic buyers of a risky asset use the asset as collateral to raise debt …nancing from less optimistic creditors. The asset’s collateral value depends on the marginal creditor’s asset valuation, and determines the buyers’purchasing capacity to bid up the asset price. Geanakoplos posits that short-term debt allows the asset buyers to maximize riskless leverage.1 As highlighted by a number of studies (e.g., Acharya, Gale, and Yorulmaker (2011), and He and Xiong (20011a, b)), short-term debt exposes the asset buyers to rollover risk, which is re‡ected in the fact that the asset buyers in Geanakoplos’model may not be able to obtain re…nancing after a negative fundamental shock. As a result, they are forced to transfer their asset holdings to the creditors, causing a leverage cycle to emerge. The presence of such rollover risk prompts a fundamental question regarding the optimality of short-term debt …nancing. Moreover, one might argue that as creditors are less optimistic and undervalue risky debt issued by optimistic asset buyers, it is not desirable for the buyers to use risky …nancing. Following Geanakoplos’framework, Simsek (2011) examines a setting in which asset buyers have to hold their positions until the asset matures. He shows that optimistic asset buyers may use risky debt …nancing despite their debt being undervalued by the creditors. The