Adverse Selection and Liquidity Distortion

41 Pages Posted: 4 Nov 2010 Last revised: 18 Sep 2012

See all articles by Briana Chang

Briana Chang

University of Wisconsin - Madison - Department of Finance, Investment and Banking

Date Written: July 2012

Abstract

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

Chang, Briana, Adverse Selection and Liquidity Distortion (July 2012). Available at SSRN: https://ssrn.com/abstract=1701997 or http://dx.doi.org/10.2139/ssrn.1701997

Briana Chang (Contact Author)

University of Wisconsin - Madison - Department of Finance, Investment and Banking ( email )

975 University Avenue
Madison, WI 53706
United States

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