Download This PaperDealer Attention, Liquidity Spillovers, and Endogenous Market Segmentation
44 Pages Posted: 15 Mar 2010 Last revised: 19 Oct 2010
Date Written: March 12, 2010
Abstract
We describe a new mechanism that explains the transmission of liquidity shocks from one security to another ("liquidity spillovers"). We consider a model in which two securities are traded by two different pools of risk averse dealers. As the payoffs of these securities are correlated, dealers in one security can learn information from the price of the other security. As securities prices are noisier when markets are less liquid, a decline in liquidity in one market spreads to the other market. As this spillover mechanism relies on dealer attention to the price of other securities, we also analyze how the cost of attention affects market liquidity. Interestingly, a reduction in the cost of attention does not necessarily improve liquidity if too few dealers pay this cost. Moreover, for some parameter values, attention decisions to prices by different dealers are complements. Thus, multiple equilibria with varying levels of attention and liquidity can emerge for the same values of the fundamentals.
Keywords: Covariations in liquidity, Dealer attention, Market segmentation, Transparency Value of Price Information
JEL Classification: G10, G12, G14
Suggested Citation: Suggested Citation
Thierry Foucault (Contact Author)
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