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

93 Pages Posted: 7 Dec 2020 Last revised: 7 Jun 2022

See all articles by Mahyar Kargar

Mahyar Kargar

University of Illinois at Urbana-Champaign - Department of Finance

Juan Passadore

Einaudi Institute for Economics and Finance (EIEF)

Dejanir Silva

Purdue University - Krannert School of Management

Date Written: November 15, 2020

Abstract

We develop an asset-pricing model with heterogeneous investors, search frictions, and wealth effects. Trade is intermediated by risk-neutral dealers subject to capacity constraints. Risk- averse investors direct their search towards dealers based on price and execution speed. Portfolio asymmetry relative to 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 trading delays. We propose a new solution method to characterize the equilibrium analytically. 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

Suggested Citation

Kargar, Mahyar and Passadore, Juan and Silva, Dejanir, Liquidity and Risk in OTC Markets: A Theory of Asset Pricing and Portfolio Flows (November 15, 2020). Available at SSRN: https://ssrn.com/abstract=3731019 or http://dx.doi.org/10.2139/ssrn.3731019

Mahyar Kargar (Contact Author)

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

Champaign, IL 61820
United States

HOME PAGE: http://mahyarkargar.com

Juan Passadore

Einaudi Institute for Economics and Finance (EIEF) ( email )

Via Due Macelli, 73
Rome, 00187
Italy

Dejanir Silva

Purdue University - Krannert School of Management ( email )

West Lafayette, IN 47907-1310
United States

HOME PAGE: http://www.dejanirsilva.com/

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