Endogenous Liquidity in Asset Markets

Abstract

This paper analyzes a model in which long-term risky assets are illiquid due to adverse selection. The degree of adverse selection and hence the liquidity of these assets is determined endogenously by the amount of trade for reasons other than private information. I find that higher productivity leads to increased liquidity. Moreover, liquidity magnifies the effects of changes in productivity on investment and volume. High productivity implies that investors initiate larger scale risky projects which increases the riskiness of their incomes. Riskier incomes induce more sales of claims to high-quality projects, causing liquidity to increase.MARKET LIQUIDITY APPEARS to vary with the state of the economy. This is evident in the variation in spreads between liquid and illiquid assets over the business cycle and in the fact that liquidity crises are associated with economic downturns. 1 Moreover, in the cross section highly productive industries and economies are associated with more liquid asset markets.This paper analyzes a model economy in which long-term risky assets vary in quality and are illiquid due to adverse selection. Investors can realize part of the value of payoffs from long-term assets early by issuing claims against the assets in a pooled market. The equilibrium claims price is determined by the average quality of claims sold. I use "liquidity" to describe the cost of transferring the value of expected future payoffs from long-term assets into current income. A lower cost implies higher liquidity. The claims price is increasing in the fraction of high-quality claims traded thus the market is more liquid when there is less adverse selection.

Market Liquidity and Funding Liquidity＊

“…This literature was initiated by Bernanke and Gertler (1989) who show that higher net wealth during booms reduces agency costs, while the lower net wealth during recessions leads to higher agency costs and tighter collateral constraints (see also Eisfeldt (2004)). Kiyotaki and Moore (1997) show in a deterministic model how a temporary productivity shock can lead to a dynamic multiplier.…”

Liquidity shocks and equilibrium liquidity premia

“…The result is stated below and proved in the appendix. 18 If the proposed candidate policy is optimal, then it is marginally optimal to invest one unit in the liquid consol at t; roll over dividends into the liquid consol before t n ; and invest only in the illiquid consol after t n : Under such a proposed policy, one unit invested at t grows to e rðsÀtÞ at any time spt n ; becomes 1 1þe e rðt n ÀtÞ shares of the illiquid consols at t n ; and pays off 1Àe 1þe e rðt n ÀtÞ exp½ R 1þe ðs À t n Þ at any time s4t n : Under the alternate policy, however, one unit invested at t becomes, at any time spt n ; 1 1þe shares of the illiquid consol (which pays off 1Àe 1þe ), plus, from the dividends rolled over into the liquid consol between time t and s; 1 1þe R s t Re rðsÀuÞ du: At s4t n ; the total illiquid consol holding is 1 1þe exp½ R 1þe ðs À t n Þ þ R ð1þeÞ 2 r ½e rðt n ÀtÞ À 1 exp½ R 1þe ðs À t n Þ ; which, when multiplied by 1 À e; gives the liquidation revenue at time s4t n : The difference between the two policies gives Eq. (25).…”

“…3 See, for example, [2,4,12,21,22,25,[34][35][36]. Also see [1,24], for example, for effect of liquidity on asset prices in the context of asymmetric information, and see [18] for a model with endogenous liquidity correlated with productivity and investment.…”

Quoted Spreads and Trade Imbalance Dynamics in the European Treasury Bond Market

“…In particular extremely favourable industrial production and unemployment news lead to a significant increase in Pr ( 0) it r = . Given the pro-cyclicality of stock market liquidity (see Eisfeldt, 2004), our results suggest that bond and stock market liquidity should be seen as substitutes rather than as complements over the business cycle. …”