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
Date Written: October 31, 2020
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
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