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Self-Fulfilling Liquidity and the Coordination Premium

Liquidity, defined as the ease with which an asset may be marketed, has a self-fulfilling dimension. If investors in the primary market for a new asset fear an illiquid secondary market, the issuance does not take off, thereby vindicating the initial concern about an illiquid secondary market. The fear of future illiquidity suffices to trigger current illiquidity. The purpose of this paper is to outline a simple model of self-fulfilling liquidity. It develops an issuance model where (i) investors are not financially constrained and (ii) have no market power, (iii) there are no transaction costs and (iv) none withholds private information. Interestingly, assets are illiquid in this frictionless world because of coordination failure among investors. There is room for coordination failure only because investors fear a future adverse selection discount if the issuance does not take off, but there is no informational concern, neither as the issuance takes place, nor in the secondary market at the equilibria. Illiquidity as a coordination failure is sufficient to predict stylized facts regarding the design and diffusion of financial innovations, without invoking the much stronger informational imperfections required in the existing literature.

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Paper provided by Carnegie Mellon University, Tepper School of Business in its series GSIA Working Papers with number 2005-E3.

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Date of creation: Nov 2004
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Handle: RePEc:cmu:gsiawp:710428070
Contact details of provider: Postal: Tepper School of Business, Carnegie Mellon University, 5000 Forbes Avenue, Pittsburgh, PA 15213-3890
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