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Portfolio choice and pricing in illiquid markets

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  • Gârleanu, Nicolae

Abstract

This paper studies portfolio choice and pricing in markets in which immediate trading may be impossible. It departs from the literature by removing restrictions on asset holdings, and finds that optimal positions depend significantly and naturally on liquidity: When expected future liquidity is high, agents take more extreme positions, given that they do not have to hold those positions for long when they become undesirable. Consequently, larger trades should be observed in markets with more frequent trading. Liquidity need not affect the price significantly, however, because liquidity has offsetting impacts on different agents' demands. This result highlights the importance of unrestricted portfolio choice. The paper draws parallels with the transaction-cost literature and clarifies the relationship between the price level and the realized trading frequency in this literature.

Suggested Citation

  • Gârleanu, Nicolae, 2009. "Portfolio choice and pricing in illiquid markets," Journal of Economic Theory, Elsevier, vol. 144(2), pages 532-564, March.
  • Handle: RePEc:eee:jetheo:v:144:y:2009:i:2:p:532-564
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    References listed on IDEAS

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    Cited by:

    1. Gara Afonso & Ricardo Lagos, 2015. "Trade Dynamics in the Market for Federal Funds," Econometrica, Econometric Society, vol. 83, pages 263-313, January.
    2. Banerjee, Snehal & Graveline, Jeremy J., 2014. "Trading in derivatives when the underlying is scarce," Journal of Financial Economics, Elsevier, vol. 111(3), pages 589-608.
    3. Kogan, Leonid & Ross, Stephen A. & Wang, Jiang & Westerfield, Mark M., 2017. "Market selection," Journal of Economic Theory, Elsevier, vol. 168(C), pages 209-236.
    4. Vayanos, Dimitri & Wang, Jiang, 2013. "Market Liquidity—Theory and Empirical Evidence ," Handbook of the Economics of Finance, Elsevier.
    5. Dimitri Vayanos & Jiang Wang, 2012. "Market Liquidity - Theory and Empirical Evidence," FMG Discussion Papers dp709, Financial Markets Group.
    6. Lischewski, Judith & Voronkova, Svitlana, 2012. "Size, value and liquidity. Do They Really Matter on an Emerging Stock Market?," Emerging Markets Review, Elsevier, vol. 13(1), pages 8-25.
    7. Bethune, Zachary & Sultanum, Bruno & Trachter, Nicholas, 2017. "Asset Issuance in Over-the-Counter Markets," Working Paper 17-13, Federal Reserve Bank of Richmond.
    8. Paul M Anglin & Yanmin Gao, 2011. "Integrating Illiquid Assets into the Portfolio Decision Process," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 39(2), pages 277-311, June.
    9. repec:fau:fauart:v:65:y:2015:i:1:p:84-104 is not listed on IDEAS
    10. Shen, Ji & Wei, Bin & Yan, Hongjun, 2016. "Financial Intermediation Chains in an OTC Market," MPRA Paper 74925, University Library of Munich, Germany.
    11. repec:eee:glofin:v:36:y:2018:i:c:p:23-40 is not listed on IDEAS
    12. French, Joseph J. & Taborda, Rodrigo, 2018. "Disentangling the relationship between liquidity and returns in Latin America," Global Finance Journal, Elsevier, vol. 36(C), pages 23-40.
    13. Kempf, Alexander & Korn, Olaf & Uhrig-Homburg, Marliese, 2012. "The term structure of illiquidity premia," Journal of Banking & Finance, Elsevier, vol. 36(5), pages 1381-1391.

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