Adverse Selection and Liquidity Distortion
41 Pages Posted: 4 Nov 2010 Last revised: 18 Sep 2012
Date Written: July 2012
This paper develops a dynamic equilibrium model of market liquidity by formalizing liquidity in terms of two dimensions: price and speed. Both of them are determined jointly by endogenous market participation. It shows how limited market participation arises in equilibrium as a result of informational frictions and how it leads to distinct notions of liquidity distortion. The model considers two-dimensional informational frictions: sellers' private information about their asset quality and also possibly about their trading motives. It demonstrates how varied informational settings lead to different predictions on the trading price and the trading volume.
Keywords: Liquidity, Search frictions, Adverse selection, Over-the-Counter, Market segmentation
JEL Classification: D82, G1
Suggested Citation: Suggested Citation