Differences of Opinion, Endogenous Liquidity, and Asset Prices
Carnegie Mellon University - David A. Tepper School of Business
March 1, 2014
Review of Financial Studies, Forthcoming
This article studies how investors' differences of opinion affect liquidity and asset prices. We construct a dynamic general-equilibrium economy in which one population of excessively optimistic investors is subject to endogenous funding constraints that prevent default due to ex-ante limited commitment. When the funding constraint binds, optimists use their savings to increase their consumption share, in order to deter default. This higher consumption share lets them place speculative trades in the market place, increasing market liquidity. Because they generally lose on these trades, they become prone to default and the likelihood of funding constraints binding increases. We show that this joint feedback between funding illiquidity, disagreement and market liquidity is consistent with several empirically documented features of liquidity and financial asset prices.
Number of Pages in PDF File: 57
Keywords: Differences of opinion, Funding liquidity, Market liquidity, Default, Stock return volatility
JEL Classification: G10, G12
Date posted: October 21, 2010 ; Last revised: January 10, 2015
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