Asset Prices and Liquidity with Market Power and Non-Gaussian Payoffs
73 Pages Posted: 15 Sep 2020 Last revised: 16 Sep 2020
Date Written: February 4, 2020
We consider an economy populated by CARA investors who trade, accounting for their price impact, multiple risky assets with arbitrary distributed payoffs. We propose a constructive solution method: finding the equilibrium reduces to solving a linear ordinary differential equation. With market power and non-Gaussian payoffs: (i) the equilibrium is nonlinear and the model can speak to key stylized facts regarding asymmetry and nonlinearity of price response to order imbalances, (ii) when risk aversion decreases, there are more liquidity providers and/or there is less uncertainty about future asset payoffs, liquidity can decrease, (iii) cross-section of returns is affected by endogenous illiquidity.
Keywords: Price Impact, Higher Cumulants, Strategic Trading, Liquidity, CAPM
JEL Classification: D21, G31, G32, G35, L11
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