Liquidity Discovery and Asset Pricing
Asset prices are risky, in part, because of uncertainty about the preferences of potential counterparties and the terms-of-trade at which they will be willing to provide liquidity in the future. We call such randomness liquidity risk. We argue that liquidity risk is an important source of asymmetric information in addition to private information about future cash flows. We model the endogenous dynamics of liquidity risk, the risk premisum for bearing liquidity risk, and the role of market trading in the liquidity discovery process through which investors learn about their counterparties' preferences and their future demands for securities. We show that market liquidity is a forward-looking predictor of future risk and, as such, is prices. Our model also provides rational explanations for "prices support levels" and "flights to quality."
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