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Theories of Liquidity

  • Vayanos, Dimitri
  • Wang, Jiang

We survey the theoretical literature on market liquidity. The literature traces illiquidity, i.e., the lack of liquidity, to underlying market imperfections. We consider six main imperfections: participation costs, transaction costs, asymmetric information, imperfect competition, funding constraints, and search. We address three questions in the context of each imperfection: (a) how to measure illiquidity, (b) how illiquidity relates to underlying market imperfections and other asset characteristics, and (c) how illiquidity affects expected asset returns. We nest all six imperfections within a common, unified model, and use that model to organize the literature.

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Article provided by now publishers in its journal Foundations and Trends(R) in Finance.

Volume (Year): 6 (2012)
Issue (Month): 4 (November)
Pages: 221-317

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Handle: RePEc:now:fntfin:0500000014
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