Liquidity in Asset Markets with Search Frictions

Abstract

We develop a search-theoretic model of financial intermediation and use it to study how trading frictions affect the distribution of asset holdings, asset prices, efficiency, and standard measures of liquidity. A distinctive feature of our theory is that it allows for unrestricted asset holdings, so market participants can accommodate trading frictions by adjusting their asset positions. We show that these individual responses of asset demands constitute a fundamental feature of illiquid markets: they are a key determinant of bid-ask spreads, trade volume, and trading delays-all the dimensions of market liquidity that search-based theories seek to explain.

Liquidity hoarding

“…Others adopt a search-theoretic model of over the counter markets and study the effect of preference shocks on market liquidity. Lagos and Rocheteau (2009) relax the indivisibility assumption found in many search models and investigate how this affects the market's adjustment to a shock. Lagos et al (2011) consider a model in which a shock reduces investors' asset demands until some randomly determined date.…”

Dynamic Trading with Predictable Returns and Transaction Costs

“…Davis and Norman (1990) provide a more formal analysis of Constantinides's model. Also,Gârleanu (2009) andLagos and Rocheteau (2009) show how search frictions and payoff meanreversion impact how close one trades to the static portfolio. Our model also shares features withLongstaff (2001) and, in the context of predatory trading, byBrunnermeier and Pedersen (2005) andCarlin, Lobo, and Viswanathan (2008).…”

The Over-the-Counter Theory of the Fed Funds Market: A Primer

“…The OTC nature of the fed funds market is stressed by Ashcraft and Duffie (2007) in their empirical investigation and used by Bech and Klee (2011), Weinberg (2009), andFurfine (2003) to explain certain aspects of interbank markets, such as apparent limits to arbitrage, stigma, and banks' decisions to borrow from standing facilities. Recent theoretical work on financial OTC markets includes Duffie, Gârleanu, and Pedersen (2005) and Lagos and Rocheteau (2009). the trading session, so τ = T − t if the current time is t ∈ [0, T ]. The reserve balance that a bank holds at time T − τ is denoted by k (τ ) ∈ K, with K = {0, 1, 2}.…”