NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Margin-Based Asset Pricing and Deviations from the Law of One Price

Nicolae Gârleanu, Lasse Heje Pedersen

NBER Working Paper No. 16777
Issued in February 2011
NBER Program(s):   AP   EFG   ME

In a model with heterogeneous-risk-aversion agents facing margin constraints, we show how securities' required returns are characterized both by their betas and their margin requirements. Negative shocks to fundamentals make margin constraints bind, lowering risk-free rates and raising Sharpe ratios of risky securities, especially for high-margin securities. Such a funding-liquidity crisis gives rise to "bases," that is, price gaps between securities with identical cash-flows but different margins. In the time series, bases depend on the shadow cost of capital, which can be captured through the interest-rate spread between collateralized and uncollateralized loans, and, in the cross section, they depend on relative margins. We test the model empirically using the CDS-bond bases and other deviations from the Law of One Price, and use it to evaluate central banks' lending facilities.

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Document Object Identifier (DOI): 10.3386/w16777

Published: Nicolae G�rleanu & Lasse Heje Pedersen, 2011. "Margin-based Asset Pricing and Deviations from the Law of One Price," Review of Financial Studies, Society for Financial Studies, vol. 24(6), pages 1980-2022.

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