SMU SOE Seminar (Oct 10, 2018, 2-3.30pm): Optimal Contract for Asset Trades: Collateralizing or Selling?

We develop a dynamic model to study the conditions under which assets are sold or used as collateral. When the borrower has an incentive to falsify the assets’ quality, they cannot be sold directly but can be used as collateral via over-collateralization. Secured loan contracts can also be optimal by reducing the lender’s incentive to acquire costly information about the assets’ future value. However, under secured loan contracts, the borrower may default opportunistically. Thus, an asset sale can be optimal under some conditions. The model also provides the theoretic explanation on the negative correlation between interest rates and haircuts.