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Financial Claustrophobia: Asset Pricing in Illiquid Markets

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  • 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.

Suggested Citation

  • Francis A. Longstaff, 2004. "Financial Claustrophobia: Asset Pricing in Illiquid Markets," NBER Working Papers 10411, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:10411
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    Cited by:

    1. Chan, Justin S.P. & Jain, Ravi & Xia, Yihong, 2008. "Market segmentation, liquidity spillover, and closed-end country fund discounts," Journal of Financial Markets, Elsevier, vol. 11(4), pages 377-399, November.
    2. Maurizio Polato & Josanco Floreani, 2010. "Distribution of Illiquid Financial Products: The Case of Italy," Transition Studies Review, Springer;Central Eastern European University Network (CEEUN), vol. 16(4), pages 848-859, February.
    3. Alessio Caldarera & Celso Brunetti, 2005. "Asset Prices and Asset Correlations in Illiquid Markets," 2005 Meeting Papers 288, Society for Economic Dynamics.
    4. Waldenström, Daniel, 2005. "Does Sovereign Risk Differ for Domestic and Foreign Investors? Historical Evidence from Scandinavian Bond Markets," SSE/EFI Working Paper Series in Economics and Finance 585, Stockholm School of Economics, revised 18 Feb 2005.
    5. Michael Ludkovski & Qunying Shen, 2013. "European Option Pricing With Liquidity Shocks," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 16(07), pages 1-30.

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    • G1 - Financial Economics - - General Financial Markets

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