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Liquidity in asset markets with search frictions

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Author Info
Ricardo Lagos
Guillaume Rocheteau

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Abstract

We study how trading frictions in asset markets affect the distribution of asset holdings, asset prices, efficiency, and standard measures of liquidity. To this end, we analyze the equilibrium and optimal allocations of a search-theoretic model of financial intermediation similar to Duffie, Gârleanu and Pedersen (2005). In contrast with the existing literature, the model we develop imposes no restrictions on asset holdings, so traders can accommodate frictions by varying their trading needs through changes in their asset positions. We find that this is a critical aspect of investor behavior in illiquid markets. A reduction in trading frictions leads to an increase in the dispersion of asset holdings and trade volume. Transaction costs and intermediaries’ incentives to make markets are nonmonotonic in trade frictions. With the entry of dealers, these nonmonotonicities give rise to an externality in liquidity provision that can lead to multiple equilibria. Tight spreads are correlated with large volume and short trading delays across equilibria. From a normative standpoint we show that the asset allocation across investors and the number of dealers are socially inefficient.

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Paper provided by Federal Reserve Bank of Cleveland in its series Working Paper with number 0706.

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Date of creation: 2007
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Handle: RePEc:fip:fedcwp:0706

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Keywords: Asset pricing ; Over-the-counter markets;

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  20. repec:rus:hseeco:72158 is not listed on IDEAS
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Gara M. Afonso, 2008. "Liquidity and congestion," Staff Reports 349, Federal Reserve Bank of New York. [Downloadable!]
  2. Ricardo Lagos & Guillaume Rocheteau, 2008. "Liquidity in asset markets with search frictions," Staff Report 408, Federal Reserve Bank of Minneapolis. [Downloadable!]
    Other versions:
  3. Bruno Biais & Pierre-Olivier Weill, 2009. "Liquidity Shocks and Order Book Dynamics," NBER Working Papers 15009, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  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. [Downloadable!]
  5. Ricardo Lagos & Guillaume Rocheteau & Pierre-Olivier Weill, 2009. "Crises and Liquidity in Over-the-Counter Markets," NBER Working Papers 15414, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  6. Sun, Yeneng & Zhang , Yongchao, 2008. "Individual Risk and Lebesgue Extension without Aggregate Uncertainty," MPRA Paper 7448, University Library of Munich, Germany. [Downloadable!]
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