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| Liquidating Illiquid Collateral (Job Market Paper) by Martin Oehmke of Princeton University November 15, 2007 Abstract: Hedge fund defaults can cause large, disorderly liquidations in financial markets. I model the dynamics of such liquidations as a continuous-time trading game, in which balance-sheet constrained prime brokers unwind illiquid collateral positions. I show that: (i) the equilibrium price of the collateral asset overshoots during liquidation when the prime brokers are sufficiently balance-sheet constrained; (ii) spreading a collateral position across multiple prime brokers alleviates balance sheet constraints, but can cause inefficient 'racing to the market', potentially reducing expected liquidation proceeds; (iii) prime brokers should take into account a hedge fund's creditor structure and their own balance sheet constraints when setting margins to manage counterparty risk; (iv) the model pins down the block price and expected profit at which a 'deep pocket' buyer can purchase the entire collateral position. Keywords: Illiquidity, Strategic Trading, Prime Brokers, Hedge Funds, Collateralized Lending, Fire Sales, Counterparty Risk Management, Block Trades. Books Referenced in this Paper: (what is this?)
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