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Search in asset markets

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Author Info
Ricardo Lagos
Guillaume Rocheteau

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Abstract

We investigate how trading frictions in asset markets affect portfolio choices, asset prices and efficiency. We generalize the search-theoretic model of financial intermediation of Duffie, Gârleanu and Pedersen (2005) to allow for more general preferences and idiosyncratic shock structure, unrestricted portfolio choices, aggregate uncertainty and entry of dealers. With a fixed measure of dealers, we show that a steady-state equilibrium exists and is unique, and provide a condition on preferences under which a reduction in trading frictions leads to an increase in the price of the asset. We also analyze the effects of trading frictions on bid-ask spreads, trade volume and the volatility of asset prices, and find that the asset allocation is constrained-inefficient unless investors have all the bargaining power in bilateral negotiations with dealers. We show that the dealers? entry decision introduces a feedback that can give rise to multiple equilibria, and that free-entry equilibria are generically inefficient.

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Paper provided by Federal Reserve Bank of Minneapolis in its series Staff Report with number 375.

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Date of creation: 2006
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Handle: RePEc:fip:fedmsr:375

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Related research
Keywords: Asset pricing ; Liquidity (Economics);

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This paper has been announced in the following NEP Reports: References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Paul Schultz, 2001. "Corporate Bond Trading Costs: A Peek Behind the Curtain," Journal of Finance, American Finance Association, vol. 56(2), pages 677-698, 04. [Downloadable!] (restricted)
  2. Pierre-Olivier Weill, 2004. "Liquidity Premia in Dynamic Bargaining Markets," Econometric Society 2004 North American Winter Meetings 648, Econometric Society. [Downloadable!]
    Other versions:
  3. Diamond, Peter A, 1982. "Aggregate Demand Management in Search Equilibrium," Journal of Political Economy, University of Chicago Press, vol. 90(5), pages 881-94, October. [Downloadable!] (restricted)
    Other versions:
  4. repec:rus:hseeco:72158 is not listed on IDEAS
  5. Vayanos, Dimitri & Weill, Pierre-Olivier, 2006. "A Search-Based Theory of the On-the-Run Phenomenon," CEPR Discussion Papers 5965, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  6. Heaton, John & Lucas, Deborah, 1995. "The importance of investor heterogeneity and financial market imperfections for the behavior of asset prices," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 42(1), pages 1-32, June. [Downloadable!] (restricted)
  7. Kiyotaki, Nobuhiro & Wright, Randall, 1993. "A Search-Theoretic Approach to Monetary Economics," American Economic Review, American Economic Association, vol. 83(1), pages 63-77, March. [Downloadable!] (restricted)
  8. Hosios, Arthur J, 1990. "On the Efficiency of Matching and Related Models of Search and Unemployment," Review of Economic Studies, Blackwell Publishing, vol. 57(2), pages 279-98, April. [Downloadable!] (restricted)
  9. Darrell Duffie & Nicolae Garleanu & Lasse Heje Pedersen, 2005. "Over-the-Counter Markets," Econometrica, Econometric Society, vol. 73(6), pages 1815-1847, November. [Downloadable!] (restricted)
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  10. Michael J. Barclay & William G. Christie & Jeffrey H. Harris & Eugene Kandel & Paul H. Schultz, 1999. "Effects of Market Reform on the Trading Costs and Depths of Nasdaq Stocks," Journal of Finance, American Finance Association, vol. 54(1), pages 1-34, 02. [Downloadable!] (restricted)
  11. Spulber, Daniel F, 1996. "Market Making by Price-Setting Firms," Review of Economic Studies, Blackwell Publishing, vol. 63(4), pages 559-80, October. [Downloadable!] (restricted)
  12. James McAndrews & Chris Stefanadis, 2000. "The emergence of electronic communications networks in the U.S. equity markets," Current Issues in Economics and Finance, Federal Reserve Bank of New York, issue Oct. [Downloadable!]
  13. Gale, Douglas, 1987. "Limit theorems for markets with sequential bargaining," Journal of Economic Theory, Elsevier, vol. 43(1), pages 20-54, October. [Downloadable!] (restricted)
  14. John Rust & George Hall, 2003. "Middlemen versus Market Makers: A Theory of Competitive Exchange," Journal of Political Economy, University of Chicago Press, vol. 111(2), pages 353-403, April. [Downloadable!] (restricted)
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  15. Pierre-Olivier Weill, 2004. "Leaning against the wind," 2004 Meeting Papers 382, Society for Economic Dynamics. [Downloadable!]
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  16. Andrei Shevchenko, 2004. "Middlemen," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 45(1), pages 1-24, 02. [Downloadable!] (restricted)
  17. Wahal, Sunil, 1997. "Entry, Exit, Market Makers, and the Bid-Ask Spread," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 10(3), pages 871-901.
  18. James P. Weston, 2000. "Competition on the Nasdaq and the Impact of Recent Market Reforms," Journal of Finance, American Finance Association, vol. 55(6), pages 2565-2598, December. [Downloadable!] (restricted)
  19. Luttmer, Erzo G J, 1996. "Asset Pricing in Economies with Frictions," Econometrica, Econometric Society, vol. 64(6), pages 1439-67, November. [Downloadable!] (restricted)
  20. He, Hua & Modest, David M, 1995. "Market Frictions and Consumption-Based Asset Pricing," Journal of Political Economy, University of Chicago Press, vol. 103(1), pages 94-117, February. [Downloadable!] (restricted)
  21. Boehmer, Ekkehart, 2005. "Dimensions of execution quality: Recent evidence for US equity markets," Journal of Financial Economics, Elsevier, vol. 78(3), pages 553-582, December. [Downloadable!] (restricted)
  22. Andrew W. Lo & Harry Mamaysky & Jiang Wang, 2004. "Asset Prices and Trading Volume under Fixed Transactions Costs," Journal of Political Economy, University of Chicago Press, vol. 112(5), pages 1054-1090, October.
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  23. Saunders, Anthony & Srinivasan, Anand & Walter, Ingo, 2002. "Price formation in the OTC corporate bond markets: a field study of the inter-dealer market," Journal of Economics and Business, Elsevier, vol. 54(1), pages 95-113. [Downloadable!] (restricted)
  24. Rubinstein, Ariel & Wolinsky, Asher, 1987. "Middlemen," The Quarterly Journal of Economics, MIT Press, vol. 102(3), pages 581-93, August. [Downloadable!] (restricted)
  25. Vayanos, Dimitri, 1998. "Transaction Costs and Asset Prices: A Dynamic Equilibrium Model," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 11(1), pages 1-58.
  26. Jianjun Miao, 2006. "A search model of centralized and decentralized trade," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 9(1), pages 68-92, January. [Downloadable!] (restricted)
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Ricardo Lagos & Guillaume Rocheteau, 2008. "Liquidity in asset markets with search frictions," Staff Report 408, Federal Reserve Bank of Minneapolis. [Downloadable!]
    Other versions:
  2. Ricardo Lagos, 2008. "The Research Agenda: Ricardo Lagos on Liquidity and the Search Theory of Money," EconomicDynamics Newsletter, Review of Economic Dynamics, vol. 10(1), November. [Downloadable!]
  3. Huberto M. Ennis & John A. Weinberg, 2007. "Interest on reserves and daylight credit," Economic Quarterly, Federal Reserve Bank of Richmond, issue Spr, pages 111-142. [Downloadable!]
  4. Veronica Guerrieri & Guido Lorenzoni, 2007. "Liquidity and Trading Dynamics," NBER Working Papers 13204, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  5. Ricardo Lagos & Guillaume Rocheteau & Pierre-Olivier Weill, 2008. "Crashes and Recoveries in Illiquid Markets," NBER Working Papers 14119, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  6. Ricardo Lagos & Guillaume Rocheteau, 2007. "Search in asset markets: market structure, liquidity, and welfare," Working Paper 0701, Federal Reserve Bank of Cleveland. [Downloadable!]
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