Asymmetric Information, Endogenous Illiquidity, and Asset Pricing with Imperfect Competition

Abstract:     
We propose a novel and tractable equilibrium model to study how information asymmetry, competition among market makers, and investors’ risk aversion affect asset pricing, market illiquidity and welfare. The main innovation is that market makers compete through choosing simultaneously quantities to buy at the bid and to sell at the ask and accordingly market clears separately at the bid and at the ask. Equilibrium bid and ask prices, bid and ask depths, trading volume and market makers’ inventory levels are all derived in closed-form. Our model can help explain some of the puzzling empirical findings, such as bid-ask spreads can be lower with asymmetric information and can be positively correlated with trading volume. In addition, we find that information asymmetry may make informed investors worse off, may reduce the welfare loss due to market power and may increase the competition among market makers in equilibrium.

Number of Pages in PDF File: 45

Keywords: Illiquidity, Bid-Ask Spread, Asymmetric Information, Imperfect Competition, Welfare

JEL Classification: D42, D53, D82, G12, G18

working papers series