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Search in asset markets

  • Ricardo Lagos
  • Guillaume Rocheteau

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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Paper provided by Federal Reserve Bank of Minneapolis in its series Staff Report with number 375.

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Date of creation: 2006
Date of revision:
Handle: RePEc:fip:fedmsr:375
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  20. Saunders, Anthony & Srinivasan, Anand & Walter, Ingo, 2002. "Price formation in the OTC corporate bond markets: a field study of the inter-dealer market," Journal of Economics and Business, Elsevier, vol. 54(1), pages 95-113.
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  28. Green, Christopher J. & Maggioni, Paolo & Murinde, Victor, 2000. "Regulatory lessons for emerging stock markets from a century of evidence on transactions costs and share price volatility in the London Stock Exchange," Journal of Banking & Finance, Elsevier, vol. 24(4), pages 577-601, April.
  29. Daniel F. Spulber, 1996. "Market Making by Price-Setting Firms," Review of Economic Studies, Oxford University Press, vol. 63(4), pages 559-580.
  30. Pierre-Olivier Weill, 2004. "Leaning against the wind," 2004 Meeting Papers 382, Society for Economic Dynamics.
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