An Information-Based Theory of Time-Varying Liquidity

67 Pages Posted: 16 Jun 2013 Last revised: 31 Mar 2016

See all articles by Brendan Daley

Brendan Daley

Johns Hopkins University

Brett S. Green

University of California, Berkeley - Haas School of Business; Washington University in St. Louis - John M. Olin Business School

Date Written: March 18, 2016

Abstract

We propose an information-based theory to explain time variation in liquidity and link it to a variety of patterns in asset markets. In "normal times," the market is fully liquid and gains from trade are realized immediately. However, the equilibrium also involves periods during which liquidity endogenously "dries up", shares remain in the hands of financially constrained traders despite gains from trade, which leads to endogenous liquidation costs. Traders correctly anticipate such costs, which reduces their willingness to pay. This foresight leads to a novel feedback effect between prices and the degree of market liquidity, which are jointly determined in equilibrium. The model also predicts that contagious sell-offs can occur after sufficiently bad news; a trade at a low price reveals information, which facilitates the trade of additional shares. Implications for efficiency and trade volume are discussed.

Keywords: Endogenous Liquidity, Asset Prices, Feedback, Asymmetric Information, Information Revelation

JEL Classification: G12, G14, C73, D82, D83

Suggested Citation

Daley, Brendan and Green, Brett S., An Information-Based Theory of Time-Varying Liquidity (March 18, 2016). Journal of Finance, 2016, 71(2), 809-870. Available at SSRN: https://ssrn.com/abstract=2279752 or http://dx.doi.org/10.2139/ssrn.2279752

Brendan Daley

Johns Hopkins University ( email )

Baltimore, MD 20036-1984
United States

Brett S. Green (Contact Author)

University of California, Berkeley - Haas School of Business ( email )

2220 Piedmont Avenue
Berkeley, CA ca 94720
United States
5105759980 (Phone)

HOME PAGE: http://faculty.haas.berkeley.edu/bgreen/

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

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