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Financial Claustrophobia: Asset Pricing in Illiquid Markets

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  • Francis A. Longstaff

Abstract

There are many examples of markets where an agent who wants to get out of an investment position quickly may find himself trapped and forced to remain in that position because of a lack of liquidity. What are the asset-pricing implications when agents cannot always buy and sell assets immediately? We study this issue in a multi-asset exchange economy with heterogeneous agents. In this model, agents can trade initially, but then cannot trade again until after a trading blackout' period. The more liquid the market, the sooner agents can trade again. Faced with illiquidity, agents abandon diversification and choose highly polarized portfolios. Risky assets are held primarily by the less-patient short-horizon agents in the economy. Polarization causes the usual risk-return tradeo. to break down and an asset's price may have more to do with the demographics of who owns it than with the riskiness of its cash flows. Risky assets are generally more valuable in an illiquid market than in a liquid market. Market illiquidity can also have large effects on the equity premium.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10411.

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Date of creation: Apr 2004
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Handle: RePEc:nbr:nberwo:10411

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Cited by:
  1. Celso Brunetti & Alessio Caldarera, 2006. "Asset Prices and asset Correlations in Illiquid Markets," Computing in Economics and Finance 2006, Society for Computational Economics 331, Society for Computational Economics.
  2. Waldenström, Daniel, 2005. "Does Sovereign Risk Differ for Domestic and Foreign Investors? Historical Evidence from Scandinavian Bond Markets," Working Paper Series in Economics and Finance 585, Stockholm School of Economics, revised 18 Feb 2005.
  3. Chan, Justin S.P. & Jain, Ravi & Xia, Yihong, 2008. "Market segmentation, liquidity spillover, and closed-end country fund discounts," Journal of Financial Markets, Elsevier, Elsevier, vol. 11(4), pages 377-399, November.
  4. Maurizio Polato & Josanco Floreani, 2010. "Distribution of Illiquid Financial Products: The Case of Italy," Transition Studies Review, Springer, Springer, vol. 16(4), pages 848-859, February.

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