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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. Ricardo Reis, 2004. "Inattentive Consumers," NBER Working Papers 10883, National Bureau of Economic Research, Inc.
    2. Pierre-Olivier Weill, 2004. "Liquidity Premia in Dynamic Bargaining Markets," Econometric Society 2004 North American Winter Meetings 648, Econometric Society.
    3. Duffie, Darrell & Garleanu, Nicolae Bogdan & Pedersen, Lasse Heje, 2006. "Valuation in Over-the-Counter Markets," CEPR Discussion Papers 5491, C.E.P.R. Discussion Papers.
    4. 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.
    5. Pierre-Olivier Weill & Dimitri Vayanos, 2007. "A Search-Based Theory of the On-the-Run Phenomenon," FMG Discussion Papers dp577, Financial Markets Group.
    6. 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.
    7. repec:bla:restud:v:74:y:2007:i:4:p:1329-1354 is not listed on IDEAS
    8. Sanford J Grossman & Guy Laroque, 2003. "Asset Pricing and Optimal Portfolio Choice in the Presence of Illiquid Durable Consumption Goods," Levine's Working Paper Archive 618897000000000803, David K. Levine.
    9. 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.
    10. Darrell Duffie & Nicolae Garleanu & Lasse Heje Pedersen, 2004. "Over-the-Counter Markets," NBER Working Papers 10816, National Bureau of Economic Research, Inc.
    11. John Y. Campbell & Albert S. Kyle, 1988. "Smart Money, Noise Trading and Stock Price Behavior," NBER Technical Working Papers 0071, National Bureau of Economic Research, Inc.
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    13. 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.
    14. D'Avolio, Gene, 2002. "The market for borrowing stock," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 271-306.
    15. Nicolae Gârleanu & Lasse Heje Pedersen, 2007. "Liquidity and Risk Management," American Economic Review, American Economic Association, vol. 97(2), pages 193-197, May.
    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. 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.
    18. Dmitrios Vayanos, 2004. "Search and Endogenous Concentration of Liquidity in Asset Markets," Econometric Society 2004 North American Winter Meetings 647, Econometric Society.
    19. Nicolae Gârleanu, 2004. "Adverse Selection and the Required Return," Review of Financial Studies, Society for Financial Studies, vol. 17(3), pages 643-665.
    20. Huang, Ming, 2003. "Liquidity shocks and equilibrium liquidity premia," Journal of Economic Theory, Elsevier, vol. 109(1), pages 104-129, March.
    21. Pierre-Olivier Weill, 2007. "Leaning Against the Wind," Review of Economic Studies, Oxford University Press, vol. 74(4), pages 1329-1354.
    22. 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. Dimitri Vayanos & Jiang Wang, 2012. "Market Liquidity — Theory and Empirical Evidence," NBER Working Papers 18251, National Bureau of Economic Research, Inc.

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