Liquidity as an Insurance Problem
Risk-averse individuals wish that assets concentrate their payoffs in states of high marginal value (that is, highly likely or low endowment states). An asset or portfolio may fail to do so, by having payoffs uncorrelated to its owner needs or, even worse, by having them inversely related. The latter, which we call tier 1 illiquidity, is shown to occur in non-Walrasian markets (where a trade involves bargaining) and in incomplete Walrasian markets where optimal trading strategies are non trivial. In both cases, the high valuation of the trader biases the equilibrium price against him. The former, which we call tier 2 illiquidity, is shown to arise when individual shocks are privately observed, because moral hazard prevents contracting on them. Diamond and Dybvig (1983) and Holmström and Tirole (1998) present prominent examples of tier 2 illiquidity. However, a self-insurance model is offered to argue that the importance of this type of illiquidity is limited from a welfare perspective, provided individuals are patient enough and can trade in a perfectly competitive, complete—except for individual-level uncertainty— set of asset markets. This article characterizes an asset's liquidity as the degree of insurance it provides, thereby identifying the basic economic problem behind liquidity as one of the familiar risk-sharing kind. It also shows, by means of examples, that the problem arises when asset markets are imperfectly competitive, incomplete, or both.
|Date of creation:||2001|
|Date of revision:|
|Contact details of provider:|| Postal: Avda. Vicuña Mackenna 4860, Macul, Santiago|
Phone: (562) 354-4303
Fax: (562) 553-1664
Web page: http://www.economia.uc.cl
More information through EDIRC
When requesting a correction, please mention this item's handle: RePEc:ioe:doctra:198. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Jaime Casassus)
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.