An Information-Based Theory of Time-Varying Liquidity

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