A Search-Based Theory of the On-the-Run Phenomenon

We propose a model in which assets with identical cash flows can trade at different prices. Infinitely-lived agents can establish long positions in a search spot market, or short positions by first borrowing an asset in a search repo market. We show that short-sellers can endogenously concentrate in one asset because of search externalities and the constraint that they must deliver the asset they borrowed. That asset enjoys greater liquidity, measured by search times, and a higher lending fee ('specialness'). Liquidity and specialness translate into price premia that are consistent with no-arbitrage. We derive closed-form solutions for small frictions, and can generate price differentials in line with observed on-the-run premia.