The More Illiquid, The More Expensive: A Search-Based Explanation of the Illiquidity Premium

49 Pages Posted: 18 Feb 2020 Last revised: 2 Nov 2020

See all articles by Jaewon Choi

Jaewon Choi

University of Illinois at Urbana-Champaign - Department of Finance; Yonsei University - School of Business

Jungsuk Han

Seoul National University - College of Business Administration; Swedish House of Finance

Sean Seunghun Shin

Aalto University - Department of Finance

Ji Hee Yoon

University College London - Department of Economics

Date Written: October 31, 2020

Abstract

Using a search-based trading model, we show that either an illiquidity price premium or discount can arise between two assets with identical fundamentals. Liquidity between the two assets diverges endogenously in a self-reinforcing manner as trading is concentrated in the more liquid asset. When buyers are marginal investors, prices are determined by buyers' tradeoff between immediacy and trading gains, generating the illiquidity price discount wherein the liquid asset is more expensive than the illiquid asset. When there is strong selling pressure, however, sellers become marginal investors and the illiquidity price premium arises, because they demand a higher selling price for the illiquid asset by trading off immediacy for trading gains. Using an identification strategy that exploits same-issuer bonds but with differing liquidity, we confirm these theoretical predictions by showing that illiquid bonds have higher prices than liquid bonds during fire-sale episodes, while liquid bonds carry higher prices in normal periods.

Keywords: OTC market, Liquidity, Flight-from-liquidity, Limits-to-arbitrage, Price pressure, Fire sale

JEL Classification: G10, G12, G20, D83

Suggested Citation

Choi, Jaewon and Han, Jungsuk and Shin, Seunghun and Yoon, Ji Hee, The More Illiquid, The More Expensive: A Search-Based Explanation of the Illiquidity Premium (October 31, 2020). Available at SSRN: https://ssrn.com/abstract=3516568 or http://dx.doi.org/10.2139/ssrn.3516568

Jaewon Choi

University of Illinois at Urbana-Champaign - Department of Finance ( email )

1206 South Sixth Street
Champaign, IL 61820
United States

HOME PAGE: http://https://sites.google.com/site/jaewchoi1203

Yonsei University - School of Business ( email )

50 Yonsei-ro, Seodaemun-gu
Seoul, 120-749
Korea, Republic of (South Korea)

Jungsuk Han (Contact Author)

Seoul National University - College of Business Administration ( email )

Seoul, 151-742
Korea, Republic of (South Korea)

Swedish House of Finance ( email )

Drottninggatan 98
111 60 Stockholm
Sweden

Seunghun Shin

Aalto University - Department of Finance ( email )

Finland

Ji Hee Yoon

University College London - Department of Economics ( email )

Drayton House, 30 Gordon Street
30 Gordon Street
London, WC1H 0AX
United Kingdom

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