Liquidity in Asset Markets with Search Frictions

56 Pages Posted: 19 Oct 2007

See all articles by Ricardo Lagos

Ricardo Lagos

New York University (NYU) - Department of Economics

Guillaume Rocheteau

Federal Reserve Bank of Cleveland; National University of Singapore (NUS)

Date Written: June 2007

Abstract

We study how trading frictions in asset markets affect the distribution of asset holdings, asset prices, efficiency, and standard measures of liquidity. To this end, we analyze the equilibrium and optimal allocations of a search-theoretic model of financial intermediation similar to Duffie, Gârleanu and Pedersen (2005). In contrast with the existing literature, the model we develop imposes no restrictions on asset holdings, so traders can accommodate frictions by varying their trading needs through changes in their asset positions. We find that this is a critical aspect of investor behavior in illiquid markets. A reduction in trading frictions leads to an increase in the dispersion of asset holdings and trade volume. Transaction costs and intermediaries' incentives to make markets are nonmonotonic in trade frictions. With the entry of dealers, these nonmonotonicities give rise to an externality in liquidity provision that can lead to multiple equilibria. Tight spreads are correlated with large volume and short trading delays across equilibria. From a normative standpoint we show that the asset allocation across investors and the number of dealers are socially inefficient.

Keywords: bid-ask spread, execution delay, liquidity, search, trade volume

JEL Classification: D83, G1

Suggested Citation

Lagos, Ricardo and Rocheteau, Guillaume, Liquidity in Asset Markets with Search Frictions (June 2007). FRB of Cleveland Working Paper No. 07-06. Available at SSRN: https://ssrn.com/abstract=1022042 or http://dx.doi.org/10.2139/ssrn.1022042

Ricardo Lagos

New York University (NYU) - Department of Economics ( email )

269 Mercer Street, 7th Floor
New York, NY 10011
United States
212-998-8937 (Phone)

Guillaume Rocheteau (Contact Author)

Federal Reserve Bank of Cleveland ( email )

PO Box 6387
Cleveland, OH 44101-1387
United States

National University of Singapore (NUS) ( email )

Bukit Timah Road 469 G
Singapore, 117591
Singapore

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