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

Abstract

In a model with multiple agents with different risk aversions facing\nmargin constraints, we show how securities’ required returns are\ncharacterized both by their beta and their margins. Negative shocks to\nfundamentals make margin constraints bind, lowering risk free rates and\nraising Sharpe ratios of risky securities, especially for high-margin\nsecurities. Such a funding liquidity crisis gives rise to a\n“basis,” that is, a price gap between securities with\nidentical cash-flows but different margins. In the time series, the\nbasis depends on the shadow cost of capital which can be captured\nthrough the interest-rate spread between collateralized and\nuncollateralized loans, and, in the cross section, it depends on\nrelative margins. We apply the model empirically to the CDS-bond basis\nand other deviations from the Law of One Price, and to evaluate the\neffects of unconventional monetary policy and lending facilities.