Outside and Inside Liquidity

Abstract (via SSRN)

Patrick Bolton
Columbia Business School – Department of Economics

Jesus (Tano) Santos
Columbia University, Columbia Business School – Economics Department; National Bureau of Economic Research (NBER)

Jose A. Scheinkman
Princeton University – Department of Economics; National Bureau of Economic Research (NBER)

We consider a model of liquidity demand arising from a possible maturity mismatch between asset revenues and consumption. This liquidity demand can be met with either cash reserves (inside liquidity) or via asset sales for cash (outside liquidity). The question we address is, what determines the mix of inside and outside liquidity in equilibrium? An important source of inefficiency in our model is the presence of asymmetric information about asset values, which increases the longer a liquidity trade is delayed. We establish existence of an immediate-trading equilibrium, in which asset trading occurs in anticipation of a liquidity shock, and sometimes also of a delayed-trading equilibrium, in which assets are traded in response to a liquidity shock. We show that, when it exists, the delayed-trading equilibrium is Pareto superior to the immediate-trading equilibrium, despite the presence of adverse selection. However, the presence of adverse selection may inefficiently accelerate asset liquidation. We also show that the delayed-trading equilibrium features more outside liquidity than the immediate-trading equilibrium although it is supplied in the presence of adverse selection. Finally, long term contracts do not always dominate the market provision of liquidity.

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20. April 2010 by Miguel Barbosa
Categories: Curated Readings, Finance & Investing | Leave a comment

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