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  • Ricardo Lagos
  • Guillaume Rocheteau

Abstract

We investigate how trading frictions in asset markets affect portfolio choices, asset prices and efficiency. We generalize the search-theoretic model of financial intermediation of Duffie, Gârleanu and Pedersen (2005) to allow for more general preferences and idiosyncratic shock structure, unrestricted portfolio choices, aggregate uncertainty and entry of dealers. With a fixed measure of dealers, we show that a steady-state equilibrium exists and is unique, and provide a condition on preferences under which a reduction in trading frictions leads to an increase in the price of the asset. We also analyze the effects of trading frictions on bid-ask spreads, trade volume and the volatility of asset prices, and find that the asset allocation is constrained-inefficient unless investors have all the bargaining power in bilateral negotiations with dealers. We show that the dealers’ entry decision introduces a feedback that can give rise to multiple equilibria, and that free-entry equilibria are generically inefficient.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Cleveland in its series Working Paper with number 0607.

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Date of creation: 2006
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Handle: RePEc:fip:fedcwp:0607

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Keywords: Asset pricing ; Portfolio management;

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References

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  29. repec:rus:hseeco:72158 is not listed on IDEAS
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Citations

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Cited by:
  1. Georges, Christophre, 2008. "Staggered updating in an artificial financial market," Journal of Economic Dynamics and Control, Elsevier, vol. 32(9), pages 2809-2825, September.
  2. Ricardo Lagos & Guillaume Rocheteau, 2007. "Liquidity in asset markets with search frictions," Working Paper 0706, Federal Reserve Bank of Cleveland.
  3. Ricardo Lagos & Guillaume Rocheteau & Pierre-Olivier Weill, 2007. "Crashes and recoveries in illiquid markets," Working Paper 0708, Federal Reserve Bank of Cleveland.
  4. Ricardo Lagos, 2008. "The Research Agenda: Ricardo Lagos on Liquidity and the Search Theory of Money," EconomicDynamics Newsletter, Review of Economic Dynamics, vol. 10(1), November.
  5. Garleanu, Nicolae Bogdan & Pedersen, Lasse Heje, 2009. "Dynamic Trading with Predictable Returns and Transaction Costs," CEPR Discussion Papers 7392, C.E.P.R. Discussion Papers.
  6. Huberto M. Ennis & John A. Weinberg, 2007. "Interest on reserves and daylight credit," Economic Quarterly, Federal Reserve Bank of Richmond, issue Spr, pages 111-142.
  7. Ricardo Lagos & Guillaume Rocheteau, 2007. "Search in asset markets: market structure, liquidity, and welfare," Working Paper 0701, Federal Reserve Bank of Cleveland.
  8. Veronica Guerrieri & Guido Lorenzoni, 2007. "Liquidity and Trading Dynamics," NBER Working Papers 13204, National Bureau of Economic Research, Inc.

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