Differences of Opinion, Endogenous Liquidity and Asset Prices
Carnegie Mellon University - David A. Tepper School of Business
This article studies how investors' differences of opinion affect liquidity and asset prices. In our economy, excessively optimistic investors are subject to an endogenous funding constraint that prevents default due to ex-ante limited commitment. When the funding constraint binds, optimists use their savings to increase their consumption share, deterring default. This allows them to place speculative trades, increasing market liquidity. Their losses on these trades make them prone to default, leading to a renewed binding of the funding constraint. This feedback between funding illiquidity, disagreement and market liquidity is consistent with several empirical features of liquidity and financial asset prices.
Number of Pages in PDF File: 63
Keywords: Differences of opinion, Funding liquidity, Market liquidity, Default, Stock return volatility
JEL Classification: G10, G12working papers series
Date posted: October 21, 2010 ; Last revised: March 31, 2014
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