Self-Fulfilling Asset Prices[Limited market participation and volatility of asset prices]

This paper explains that anticipated market liquidity is an important concern for arbitrageurs considering entry into a market, a concern that can generate self-fulfilling asset prices. In the model, fixed investment costs turn a market illiquid and generate an arbitrage opportunity. The worst-case return on pledged collateral constrains arbitrageurs’ leverage. The interaction between this return and arbitrageurs’ capital makes entry decisions complementary and can create multiple equilibria. When arbitrageurs enter with capital, the market becomes more liquid; the worst-case return rises; and more arbitrageurs enter with capital. When arbitrageurs withhold capital, the market stays illiquid; the worst-case return falls; and other arbitrageurs stay out. (JEL D84, G11, G12)Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.