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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 Minneapolis in its series Staff Report with number 375.

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Date of creation: 2006
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Handle: RePEc:fip:fedmsr:375

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Keywords: Asset pricing ; Liquidity (Economics);

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References

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Citations

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Cited by:
  1. 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.
  2. Pierre-Olivier Weill & Guillaume Rocheteau & Ricardo Lagos, 2007. "Crashes and Recoveries in Illiquid Markets," 2007 Meeting Papers 981, Society for Economic Dynamics.
  3. Ricardo Lagos & Guillaume Rocheteau, 2007. "Search in asset markets: market structure, liquidity, and welfare," Working Paper 0701, Federal Reserve Bank of Cleveland.
  4. Georges, Christophre, 2008. "Staggered updating in an artificial financial market," Journal of Economic Dynamics and Control, Elsevier, vol. 32(9), pages 2809-2825, September.
  5. Veronica Guerrieri & Guido Lorenzoni, 2009. "Liquidity and Trading Dynamics," Econometrica, Econometric Society, vol. 77(6), pages 1751-1790, November.
  6. Guillaume Rocheteau & Ricardo Lagos, 2008. "Liquidity in asset markets with search frictions," Working Paper 0804, Federal Reserve Bank of Cleveland.
  7. 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.
  8. Nicolae B. Garleanu & Lasse H. Pedersen, 2009. "Dynamic Trading with Predictable Returns and Transaction Costs," NBER Working Papers 15205, National Bureau of Economic Research, Inc.

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