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Liquidity as an Insurance Problem


  • Felipe Zurita

    () (Instituto de Economía. Pontificia Universidad Católica de Chile.)


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.

Suggested Citation

  • Felipe Zurita, 2001. "Liquidity as an Insurance Problem," Documentos de Trabajo 198, Instituto de Economia. Pontificia Universidad Católica de Chile..
  • Handle: RePEc:ioe:doctra:198

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    References listed on IDEAS

    1. Bhattacharya Sudipto & Thakor Anjan V., 1993. "Contemporary Banking Theory," Journal of Financial Intermediation, Elsevier, vol. 3(1), pages 2-50, October.
    2. Grossman, Sanford J & Stiglitz, Joseph E, 1980. "On the Impossibility of Informationally Efficient Markets," American Economic Review, American Economic Association, vol. 70(3), pages 393-408, June.
    3. Bhattacharya, Utpal & Spiegel, Matthew, 1991. "Insiders, Outsiders, and Market Breakdowns," Review of Financial Studies, Society for Financial Studies, vol. 4(2), pages 255-282.
    4. Milgrom, Paul & Stokey, Nancy, 1982. "Information, trade and common knowledge," Journal of Economic Theory, Elsevier, vol. 26(1), pages 17-27, February.
    5. Leland, Hayne E & Pyle, David H, 1977. "Informational Asymmetries, Financial Structure, and Financial Intermediation," Journal of Finance, American Finance Association, vol. 32(2), pages 371-387, May.
    6. Allen, Franklin, 1990. "The market for information and the origin of financial intermediation," Journal of Financial Intermediation, Elsevier, vol. 1(1), pages 3-30, March.
    7. Riley, John G, 1979. "Informational Equilibrium," Econometrica, Econometric Society, vol. 47(2), pages 331-359, March.
    8. Glosten, Lawrence R, 1989. "Insider Trading, Liquidity, and the Role of the Monopolist Specialist," The Journal of Business, University of Chicago Press, vol. 62(2), pages 211-235, April.
    9. George A. Akerlof, 1970. "The Market for "Lemons": Quality Uncertainty and the Market Mechanism," The Quarterly Journal of Economics, Oxford University Press, vol. 84(3), pages 488-500.
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    Cited by:

    1. Felipe Zurita, 2008. "Liquidity and market incompleteness," Annals of Finance, Springer, vol. 4(3), pages 299-303, July.
    2. Felipe Zurita, 2003. "Liquidity and Financial Markets - Introduction," Latin American Journal of Economics-formerly Cuadernos de Economía, Instituto de Economía. Pontificia Universidad Católica de Chile., vol. 40(121), pages 725-727.

    More about this item


    Liquidity; insurance;

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies


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