Liquidity and Asset Prices: A Unified Framework (original) (raw)

Liquidity and Asset Returns Under Asymmetric Information and Imperfect Competition

Review of Financial Studies, 2012

We analyze how asymmetric information and imperfect competition affect liquidity and asset prices. Our model has three periods: agents are identical in the first, become heterogeneous and trade in the second, and consume asset payoffs in the third. We show that asymmetric information in the second period raises ex ante expected asset returns in the first, comparing both to the case where all private signals are made public and to that where private signals are not observed. Imperfect competition can instead lower expected returns. Each imperfection can move common measures of illiquidity in opposite directions. * This paper was previously circulated under the title "Liquidity and Asset Prices: A Unified Framework." The previous version incorporates a number of additional market frictions to asymmetric information and imperfect competition. We thank Viral Acharya,

Search and endogenous concentration of liquidity in asset markets

Journal of Economic Theory, 2007

We develop a search-based model of asset trading, in which investors of different horizons can invest in two assets with identical payoffs. The asset markets are partially segmented: buyers can search for only one asset, but can decide which one. We show the existence of a "clientele" equilibrium where all short-horizon investors search for the same asset. This asset has more buyers and sellers, lower search times, and trades at a higher price relative to its identical-payoff counterpart. The clientele equilibrium dominates the one where all investor types split equally across assets, implying that the concentration of liquidity is socially desirable. 67 cases, however, asymmetric information cannot be the explanation for liquidity differences. For example, AAA-rated bonds of US corporations are essentially default-free, but are significantly less liquid than Treasury bonds. Since both sets of bonds have essentially riskless cash flows, their value should depend only on interest rates. But information about the latter is generally symmetric, and in any event, possible asymmetries should be common across bonds. An even starker example comes from within the Treasury market: just-issued ("on-the-run'') bonds are significantly more liquid than previously issued ("off-the-run'') bonds maturing on nearby dates. In this paper we explore an alternative theory of liquidity based on the notion that asset trading can involve search, i.e., locating counterparties takes time. Search is a fundamental feature of over-the-counter markets, where trade is conducted through bilateral negotiations rather than a Walrasian auction. We show that liquidity, measured by search costs, can differ across otherwise identical assets, and this translates into equilibrium price differentials. We also perform a welfare analysis, showing that the concentration of liquidity in one asset dominates equal liquidity in all assets.

Theories of Liquidity

We survey the theoretical literature on market liquidity. The literature traces illiquidity, i.e., the lack of liquidity, to underlying market imperfections. We consider six main imperfections: participation costs, transaction costs, asymmetric information, imperfect competition, funding constraints, and search. We address three questions in the context of each imperfection: (a) how to measure illiquidity, (b) how illiquidity relates to underlying market imperfections and other asset characteristics, and (c) how illiquidity affects expected asset returns. We nest all six imperfections within a common, unified model, and use that model to organize the literature.

Theory-Based Illiquidity and Asset Pricing

Review of Financial Studies, 2009

Many proxies of illiquidity have been used in the literature that relates illiquidity to asset prices. These proxies have been motivated from an empirical standpoint. In this study, we approach liquidity estimation from a theoretical perspective. Our method explicitly recognizes the analytic dependence of illiquidity on more primitive drivers such as trading activity and information asymmetry. More specifically, we estimate illiquidity using structural formulae in line with lambda for a comprehensive sample of stocks. The empirical results provide convincing evidence that theory-based estimates of illiquidity are priced in the cross-section of expected stock returns, even after accounting for risk factors, firm characteristics known to influence returns, and other illiquidity proxies prevalent in the literature. the context of Kyle lambdas. Section 2 describes the methodology. Section 3 outlines the data, definitions, and descriptive statistics. Section 4 discusses the empirical results and robustness checks. In Section 5, we compare the effects of the theory-based measures with those of other alternative (il)liquidity measures. Section 6 concludes.

Asset markets and endogenous liquidity

2000

In financial markets characterized by imperfect depth, speculative trading will have tran-sitory effects on the market price as market makers must be compensated for the risk of holding the asset. The number of people providing liquidity to a market will generally be ...

Asset Pricing and the Illiquidity Premium

The Financial Review, 2005

Acknowledgments: The authors are pleased to acknowledge the very helpful comments of two anonymous referees and the expert assistance of Frida Lie and Ali Suleyman. Abstract: In this paper, we examine the asset pricing role of liquidity (as proxied by share turnover) in the context of the Fama and French three-factor model. Our analysis employs monthly Australian data, covering the sample period 1990 to 1998. The key finding of our research is that the GMM test is unable to reject the test of over-identifying restrictions -thus supporting the overall favourability of the liquidity augmented Fama-French model.

Pricing and Liquidity in Decentralized Asset Markets

I develop a search-and-bargaining model of endogenous intermediation in over-the-counter markets. Unlike the existing work, my model allows for rich investor heterogeneity in three simultaneous dimensions: preferences, inventories, and meeting rates. By comparing trading-volume patterns that arise in my model and are observed in practice, I argue that the heterogeneity in meeting rates is the main driver of intermediation patterns. I find that investors with higher meeting rates (i.e., fast investors) are less averse to holding inventories and more attracted to cash earnings, which makes the model corroborate a number of stylized facts that do not emerge from existing models: (i) fast investors provide intermediation by charging a speed premium, and (ii) fast investors hold more extreme inventories. Then, I use the model to study the effect of trading frictions on the supply and price of liquidity. On social welfare, I show that the interaction of meeting rate heterogeneity with optimal inventory management makes the equilibrium inefficient. I provide a financial transaction tax/subsidy scheme that corrects this inefficiency, in which fast investors cross-subsidize slow investors.

Asset Prices and asset Correlations in Illiquid Markets

2006

We build a new asset pricing framework to study the effects of aggregate illiquidity on asset prices, volatilities and correlations. In our framework the Black-Scholes economy is obtained as the limiting case of perfectly liquid markets. The model is consistent with empirical studies on the effects of illiquidity on asset returns, volatilities and correlations. We present the model, study its