Working Paper

Portfolio Choice and Settlement Frictions: A Theory of Endogenous Convenience Yields

Abstract: We study settlement frictions that arise from the need to finance negative balances through an over-the-counter (OTC) market. We derive a closed-form expression for the endogenous convenience yield and show how it can be incorporated into a canonical portfolio problem. Using this framework, we examine how shifts in settlement frictions affect liquidity premia, the volume of overnight funding, the dispersion of market rates, and optimal portfolio allocations. From a normative perspective, we show that in the competitive equilibrium, investors may either over- or under-invest in liquid assets; moreover, both higher risk aversion and tighter aggregate liquidity increase the likelihood of under-accumulation.

JEL Classification: E52; G12; G21; E51; E58;

https://doi.org/10.21034/wp.812

Bibliographic Information

Provider: Federal Reserve Bank of Minneapolis

Part of Series: Working Papers

Publication Date: 2025-11-19

Number: 812