Working Paper: NBER ID: w10411
Authors: Francis A. Longstaff
Abstract: There are many examples of markets where an agent who wants to get out of an investment position quickly may find himself trapped and forced to remain in that position because of a lack of liquidity. What are the asset-pricing implications when agents cannot always buy and sell assets immediately? We study this issue in a multi-asset exchange economy with heterogeneous agents. In this model, agents can trade initially, but then cannot trade again until after a trading blackout' period. The more liquid the market, the sooner agents can trade again. Faced with illiquidity, agents abandon diversification and choose highly polarized portfolios. Risky assets are held primarily by the less-patient short-horizon agents in the economy. Polarization causes the usual risk-return tradeo. to break down and an asset's price may have more to do with the demographics of who owns it than with the riskiness of its cash flows. Risky assets are generally more valuable in an illiquid market than in a liquid market. Market illiquidity can also have large effects on the equity premium.
Keywords: No keywords provided
JEL Codes: G1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Market liquidity (G19) | Asset valuations (G19) |
| Illiquid markets (G19) | Abandon diversification (F12) |
| Abandon diversification (F12) | Polarized portfolios (G11) |
| Less patient agents (L85) | Riskier assets (G19) |
| More patient agents (I11) | Safer assets (G19) |
| Market liquidity increases (G19) | Equity premium (varies) (G12) |
| Less patient agents (L85) | Welfare losses from illiquidity (G33) |