Crashes And Collateralized Lending

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Executive Summary

This paper develops a parsimonious static model for characterizing financing terms in collateralized lending markets. The authors characterize the systematic risk exposures for a variety of securities and develop a simple indifference-pricing framework to value the systematic crash risk exposure of the collateral. They then apply Modigliani and Miller's (1958) Proposition Two (MM) to split the cost of bearing this risk between the borrower and lender, resulting in a schedule of haircuts and financing rates.

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