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Liquidity cost premia.

Article Excerpt
Abstract

The purpose of the paper is to find out the borrowing cost premia for those individuals who are liquidity-constrained, or who are first-time buyers of real estate. The analysis uses the similarity of a leveraged purchase with the exercise of a call option to defer the purchase of the asset. Sensible parameters are selected for the option, and simulations are run to identify the cost premia. The main conclusion is that these borrowing costs are prohibitive in central tendency and in dispersion. This means that liquidity-constrained individuals may be given borrowing quotations, but these quoted rates are so high and variable that these individuals are unwilling to borrow. (JEL C88, E43, G13)

Keywords: liquidity constraints, borrowing cost premia, call option to defer, real estate economics, computer simulation

Introduction

This paper is intended to provide estimates by simulation of borrowing risk premia, i.e., spreads over a risk-less return, applicable to those individuals who are likely to be liquidity-constrained, or first-time borrowers. The simulations show that the risk premia are, as expected, prohibitive in central tendency and in dispersion. The analysis is based on a concept related to that of a real option [Hull, 2003]: the option to defer the purchase of an asset. The asset under consideration is a real estate for two reasons. One, liquidity constraints usually arise with the acquisition of such assets. Two, the asset can be rented if the purchase is deferred.

The analysis assumes that the lender knows the credit of the borrower. This is reasonable nowadays in mortgage markets [Frame and White, 2005, pp. 165-166]. That is why the approach in this study runs counter to the legacy of the literature on information asymmetry [Akerlof, 1970; Stiglitz and Weiss, 1981; Spencer, 2000]. Instead of pooling arrangements, like the setting of a single loan rate to all borrowers because of incomplete information, differential loan rates are quoted depending on the credit history of the borrower. For example, in the 1980s, the financial markets were witnessing the issuance of high-yield junk bonds. The issuers of these bonds knew the bad credit of the borrowers.

It is becoming easy, and much easier, to find out the credit worthiness of a borrower and to adjust the loan rate accordingly. Moreover, nowadays borrowers are disciplined by leverage because they know that they need to build a credit history, and that they will be back in the credit market in the future. If they pay their financial dues on time and regularly this will help in facilitating future borrowing and improving the terms under which they will borrow. The end result is more future consumption and, therefore, more utility.

The only requirement for fixing a loan rate to a borrower is the knowledge of some four to five parameters. Some of these parameters are the same for all: the risk-less return and the volatility of the asset. Other parameters are under the control of the borrower, like the rent yield, the deferral period, and whether the call...

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