Endogenous Liquidity in Asset Markets


  • Andrea L. Eisfeldt

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    • Eisfeldt is with the Kellogg School of Management, Northwestern University. This paper is a revised version of my dissertation thesis at the University of Chicago. I thank my advisors John Cochrane, Douglas Diamond and Lars Hansen, as well as Adriano Rampini, and Ronel Elul, Beatrix Paal, Nancy Stokey, Dimitri Vayanos, Jaume Ventura, Annette Vissing-Jørgenson; an anonymous referee; the editor, Rick Green; and seminar participants at Berkeley, Carnegie Mellon, Columbia, Harvard, Northwestern, Stanford, UCLA, University of Chicago, University of Illinois, University of Michigan, Wharton, the SED Annual Meeting, The Accounting and Finance conference in Tel Aviv, The Information, Financial Markets and the Business Cycle Conference in Rome, the AEA annual meeting, the SAET Biannual Meeting, the WFA Annual Meeting, and the Liquidity Concepts and Financial Instabilities Conference in Eltville for helpful comments. Financial support from the Margaret Reid Dissertation Fellowship and the University of Chicago is gratefully acknowledged. All errors are mine.


This paper analyzes a model in which long-term risky assets are illiquid due to adverse selection. The degree of adverse selection and hence the liquidity of these assets is determined endogenously by the amount of trade for reasons other than private information. I find that higher productivity leads to increased liquidity. Moreover, liquidity magnifies the effects of changes in productivity on investment and volume. High productivity implies that investors initiate larger scale risky projects which increases the riskiness of their incomes. Riskier incomes induce more sales of claims to high-quality projects, causing liquidity to increase.