Liquidity and Risk in OTC Markets: A Theory of Asset Pricing and Portfolio Flows

Abstract

We incorporate wealth effects into search models of over-the-counter markets and propose an asset-pricing model with heterogeneous investors and search frictions. Risk-averse investors direct their search toward capacity-constrained dealers based on price and execution speed. Portfolio asymmetry relative to the target amplifies the risk premium, and portfolio dispersion leads to a decline in the risk-free rate and higher trading volume, bid-ask spreads, and execution delays. We use global perturbation methods to characterize the equilibrium analytically. Our model’s quantitative implications for asset prices and liquidity conditions in response to a large adverse shock are consistent with the evidence from March 2020.

Keywords: Asset pricing, competitive search, market liquidity, perturbation techniques

JEL Classification: G11, G12, D53