Differences of Opinion, Endogenous Liquidity, and Asset Prices

Review of Financial Studies 28(7): 1914–1959, 2015

57 Pages Posted: 21 Oct 2010 Last revised: 17 Aug 2016

Emilio Osambela

Board of Governors of the Federal Reserve System

Date Written: March 1, 2014

Abstract

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.

Keywords: Differences of opinion, Funding liquidity, Market liquidity, Default, Stock return volatility

JEL Classification: G10, G12

Suggested Citation

Osambela, Emilio, Differences of Opinion, Endogenous Liquidity, and Asset Prices (March 1, 2014). Review of Financial Studies 28(7): 1914–1959, 2015. Available at SSRN: https://ssrn.com/abstract=1694330 or http://dx.doi.org/10.2139/ssrn.1694330

Emilio Osambela (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Paper statistics

Downloads
448
Rank
50,740
Abstract Views
2,793