This paper investigates how the degree of trading frictions in asset markets affects portfolio allocations, asset prices, efficiency, and several measures of liquidity, such as execution delays, bid-ask spreads, and trade volumes. To this end, we generalize the search-theoretic model of financial intermediation of Duffie, Garleanu and Pedersen (2005) to allow for more general preferences and idiosyncratic shock structure, unrestricted portfolio choices, aggregate uncertainty, and entry of financial intermediaries (dealers). Investors are subject to shocks that periodically change their desired asset holdings, and contact dealers to rebalance their portfolios. Investors and dealers are matched bilaterally according to a stochastic, time-consuming process, and the latter have instantaneous access to a competitive (inter-dealer) market for the asset. We study the model with a fixed measure of dealers and show that a steady-state equilibrium exists and is unique. We provide a simple condition on preferences under which a reduction in trading frictions (e.g., a reduction in execution delays) will lead to an increase in the price of the asset. We also study the connection between the volatility of asset prices and the degree of trading frictions. From a normative standpoint, we find that the asset allocation is constrained-inefficient unless investors have all the bargaining power in bilateral negotiations with dealers. We also analyze the model with entry of dealers, thereby endogenizing the extent of the trading frictions. We show that the dealers' entry decision introduces a feedback that can give rise to multiple equilibria, and construct examples. With entry, we find that both the portfolio allocation across investors and the number of dealers are socially inefficient
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Paper provided by Society for Economic Dynamics in its series 2006 Meeting Papers with number
869.
Length: Date of creation: 03 Dec 2006 Date of revision: Handle: RePEc:red:sed006:869
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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.:
Darrell Duffie & Nicolae Garleanu & Lasse Heje Pedersen, 2004.
"Over-the-Counter Markets,"
NBER Working Papers
10816, National Bureau of Economic Research, Inc.
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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.
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