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Adverse Selection and Liquidity Distortion in Decentralized Markets

  • Briana Chang

    (Northwestern University)

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    This paper studies the competitive equilibrium outcome in decentralized asset markets when both search friction and adverse selection play roles. In a dynamic environment with heterogeneous sellers and buyers, I show how adverse selection leads to the downward distortion of equilibrium market liquidity. The model predicts a strong link between the market liquidity and the underlying uncertainty stemming from adverse selection and therefore provides an explanation for the existence of massive illiquidity. As our setup captures two important dimensions in the trading market, price and liquidity, it shows how price and liquidity are jointly determined as an equilibrium outcome and further sheds lights on market segmentation. The framework also allows for a richer analysis of how sorting pattern is determined in such an environment and how different market segmentation may arise when sellers' motives for sale are unknown to the market.

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    File URL: https://www.economicdynamics.org/meetpapers/2011/paper_157.pdf
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    Paper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 157.

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    Date of creation: 2011
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    Handle: RePEc:red:sed011:157
    Contact details of provider: Postal: Society for Economic Dynamics Christian Zimmermann Economic Research Federal Reserve Bank of St. Louis PO Box 442 St. Louis MO 63166-0442 USA
    Fax: 1-314-444-8731
    Web page: http://www.EconomicDynamics.org/society.htm
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    1. Douglas Gale, 1994. "Equilibria and Pareto Optima of Markets with Adverse Selection," Papers 0046, Boston University - Industry Studies Programme.
    2. Ricardo Lagos & Guillaume Rocheteau, 2007. "Liquidity in asset markets with search frictions," Working Paper 0706, Federal Reserve Bank of Cleveland.
    3. Robert Shimer & Randall Wright & Veronica Guerrieri, 2009. "Adverse Selection in Competitive Search Equilibrium," 2009 Meeting Papers 139, Society for Economic Dynamics.
    4. Gavazza, Alessandro, 2010. "The role of trading frictions in real asset markets," MPRA Paper 25781, University Library of Munich, Germany.
    5. Pierre-Olivier Weill, 2004. "Liquidity Premia in Dynamic Bargaining Markets," Econometric Society 2004 North American Winter Meetings 648, Econometric Society.
    6. Bachmann, Ruediger & Bayer, Christian, 2009. "The cross-section of firms over the business cycle: new facts and a DSGE exploration," Discussion Paper Series 1: Economic Studies 2009,17, Deutsche Bundesbank, Research Centre.
    7. Darrell Duffie & Nicolae Garleanu & Lasse Heje Pedersen, 2004. "Over-the-Counter Markets," NBER Working Papers 10816, National Bureau of Economic Research, Inc.
    8. Moen, E.R., 1995. "Competitive Search Equilibrium," Memorandum 37/1995, Oslo University, Department of Economics.
    9. Jan Eeckhout & Philipp Kircher, 2008. "Sorting and Decentralized Price Competition," PIER Working Paper Archive 08-020, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
    10. Thorsten V. Koeppl & Jonathan Chiu, 2010. "Market Freeze and Recovery: Trading Dynamics under Optimal Intervention by a Market-Maker-of-Last-Resort," 2010 Meeting Papers 78, Society for Economic Dynamics.
    11. Warusawitharana, Missaka, 2008. "Corporate asset purchases and sales: Theory and evidence," Journal of Financial Economics, Elsevier, vol. 87(2), pages 471-497, February.
    12. Yoonsoo Lee & Toshihiko Mukoyama, 2008. "Entry, exit and plant-level dynamics over the business cycle," Working Paper 0718, Federal Reserve Bank of Cleveland.
    13. Vojislav Maksimovic, 2001. "The Market for Corporate Assets: Who Engages in Mergers and Asset Sales and Are There Efficiency Gains?," Journal of Finance, American Finance Association, vol. 56(6), pages 2019-2065, December.
    14. Shi, Shouyong, 2001. "Frictional Assignment. I. Efficiency," Journal of Economic Theory, Elsevier, vol. 98(2), pages 232-260, June.
    15. Milgrom, P. & Shannon, C., 1991. "Monotone Comparative Statics," Papers 11, Stanford - Institute for Thoretical Economics.
    16. Eisfeldt, Andrea L. & Rampini, Adriano A., 2006. "Capital reallocation and liquidity," Journal of Monetary Economics, Elsevier, vol. 53(3), pages 369-399, April.
    17. Dale T. Mortensen & Randall Wright, 2002. "Competitive Pricing and Efficiency in Search Equilibrium," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 43(1), pages 1-20, February.
    18. Nicholas Bloom, 2009. "The Impact of Uncertainty Shocks," Econometrica, Econometric Society, vol. 77(3), pages 623-685, 05.
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