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Liquidity Discovery and Asset Pricing

  • Burton Hollifield
  • Michael Gallmeyer
  • Duane Seppi

Most investors purchase securities knowing they will resell those securities in the future. Uncertainty about the preferences of future trading counter-parties causes randomness in future resale prices that we call liquidity risk. It is natural to suppose that investors are asymmetrically informed about liquidity risk. Through a process of liquidity discovery, trading volumes and prices reveal private information about future counter-party preferences. The liquidity discovery process leads to endogenous joint dynamics for prices, trading volume, volatility, and expected returns. In particular, market liquidity is a forward-looking predictor of future liquidity risk and, as such, is priced. Liquidity discovery provides an alternative explanation to transaction costs for the relationships between current market liquidity measures and future returns

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Paper provided by Society for Economic Dynamics in its series 2004 Meeting Papers with number 136a.

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Date of creation: 2004
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Handle: RePEc:red:sed004:136a
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

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