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Portfolio choice and pricing in illiquid markets

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  • Gârleanu, Nicolae
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    Abstract

    This paper studies portfolio choice and pricing in markets in which immediate trading may be impossible. It departs from the literature by removing restrictions on asset holdings, and finds that optimal positions depend significantly and naturally on liquidity: When expected future liquidity is high, agents take more extreme positions, given that they do not have to hold those positions for long when they become undesirable. Consequently, larger trades should be observed in markets with more frequent trading. Liquidity need not affect the price significantly, however, because liquidity has offsetting impacts on different agents' demands. This result highlights the importance of unrestricted portfolio choice. The paper draws parallels with the transaction-cost literature and clarifies the relationship between the price level and the realized trading frequency in this literature.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Economic Theory.

    Volume (Year): 144 (2009)
    Issue (Month): 2 (March)
    Pages: 532-564

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    Handle: RePEc:eee:jetheo:v:144:y:2009:i:2:p:532-564

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    Web page: http://www.elsevier.com/locate/inca/622869

    Related research

    Keywords: Liquidity Discount Portfolio choice Trading delays Search Transaction costs;

    References

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    1. Grossman, Sanford J & Laroque, Guy, 1990. "Asset Pricing and Optimal Portfolio Choice in the Presence of Illiquid Durable Consumption Goods," Econometrica, Econometric Society, vol. 58(1), pages 25-51, January.
    2. Mark Mitchell & Lasse Heje Pedersen & Todd Pulvino, 2007. "Slow Moving Capital," NBER Working Papers 12877, National Bureau of Economic Research, Inc.
    3. Darrell Duffie & Nicolae Garleanu & Lasse Heje Pedersen, 2005. "Over-the-Counter Markets," Econometrica, Econometric Society, vol. 73(6), pages 1815-1847, November.
    4. Harrison, J Michael & Kreps, David M, 1978. "Speculative Investor Behavior in a Stock Market with Heterogeneous Expectations," The Quarterly Journal of Economics, MIT Press, vol. 92(2), pages 323-36, May.
    5. Vayanos, Dimitri, 1998. "Transaction Costs and Asset Prices: A Dynamic Equilibrium Model," Review of Financial Studies, Society for Financial Studies, vol. 11(1), pages 1-58.
    6. Campbell, J.Y. & Kyle, A.S., 1988. "Smart Money, Noise Trading And Stock Price Behavior," Papers 95, Princeton, Department of Economics - Financial Research Center.
    7. Darrell Duffie & Nicolae Gârleanu & Lasse Heje Pedersen, 2007. "Valuation in Over-the-Counter Markets," Review of Financial Studies, Society for Financial Studies, vol. 20(6), pages 1865-1900, November.
    8. Dimitri Vayanos & Pierre-Olivier Weill, 2008. "A Search-Based Theory of the On-the-Run Phenomenon," Journal of Finance, American Finance Association, vol. 63(3), pages 1361-1398, 06.
    9. Nicolae Gârleanu & Lasse Heje Pedersen, 2007. "Liquidity and Risk Management," American Economic Review, American Economic Association, vol. 97(2), pages 193-197, May.
    10. Pierre-Olivier Weill, 2004. "Liquidity Premia in Dynamic Bargaining Markets," Econometric Society 2004 North American Winter Meetings 648, Econometric Society.
    11. Pierre-Olivier Weill, 2007. "Leaning Against the Wind," Review of Economic Studies, Oxford University Press, vol. 74(4), pages 1329-1354.
    12. Ricardo Reis, 2004. "Inattentive Consumers," NBER Working Papers 10883, National Bureau of Economic Research, Inc.
    13. Xavier Gabaix & David Laibson, 2002. "The 6D Bias and the Equity Premium Puzzle," Harvard Institute of Economic Research Working Papers 1947, Harvard - Institute of Economic Research.
    14. Huang, Ming, 2003. "Liquidity shocks and equilibrium liquidity premia," Journal of Economic Theory, Elsevier, vol. 109(1), pages 104-129, March.
    15. Vayanos, Dimitri & Wang, Tan, 2007. "Search and endogenous concentration of liquidity in asset markets," Journal of Economic Theory, Elsevier, vol. 136(1), pages 66-104, September.
    16. Amihud, Yakov & Mendelson, Haim, 1986. "Asset pricing and the bid-ask spread," Journal of Financial Economics, Elsevier, vol. 17(2), pages 223-249, December.
    17. Nicolae Gârleanu, 2004. "Adverse Selection and the Required Return," Review of Financial Studies, Society for Financial Studies, vol. 17(3), pages 643-665.
    18. Geczy, Christopher C. & Musto, David K. & Reed, Adam V., 2002. "Stocks are special too: an analysis of the equity lending market," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 241-269.
    19. Adam B. Ashcraft & Darrell Duffie, 2007. "Systemic Illiquidity in the Federal Funds Market," American Economic Review, American Economic Association, vol. 97(2), pages 221-225, May.
    20. D'Avolio, Gene, 2002. "The market for borrowing stock," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 271-306.
    21. Constantinides, George M, 1986. "Capital Market Equilibrium with Transaction Costs," Journal of Political Economy, University of Chicago Press, vol. 94(4), pages 842-62, August.
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    Cited by:
    1. Lischewski, Judith & Voronkova, Svitlana, 2012. "Size, value and liquidity. Do They Really Matter on an Emerging Stock Market?," Emerging Markets Review, Elsevier, vol. 13(1), pages 8-25.
    2. Paul M Anglin & Yanmin Gao, 2011. "Integrating Illiquid Assets into the Portfolio Decision Process," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 39(2), pages 277-311, 06.
    3. Kempf, Alexander & Korn, Olaf & Uhrig-Homburg, Marliese, 2012. "The term structure of illiquidity premia," Journal of Banking & Finance, Elsevier, vol. 36(5), pages 1381-1391.
    4. Dimitri Vayanos & Jiang Wang, 2012. "Market Liquidity - Theory and Empirical Evidence," FMG Discussion Papers dp709, Financial Markets Group.
    5. Banerjee, Snehal & Graveline, Jeremy J., 2014. "Trading in derivatives when the underlying is scarce," Journal of Financial Economics, Elsevier, vol. 111(3), pages 589-608.

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