Foundations and Trends® in Finance > Vol 6 > Issue 4

Theories of Liquidity

Dimitri Vayanos, London School of Economics, CEPR and NBER, UK, d.vayanos@lse.ac.uk Jiang Wang, Massachusetts Institute of Technology, CAFR and NBER, USA, wangj@mit.edu
 
Suggested Citation
Dimitri Vayanos and Jiang Wang (2012), "Theories of Liquidity", Foundations and TrendsĀ® in Finance: Vol. 6: No. 4, pp 221-317. http://dx.doi.org/10.1561/0500000014

Published: Nov 19, 2012
© 2012 D. Vayanos and J. Wang
 
Subjects
Asset pricing,  Financial markets,  Economic Theory
 
Keywords
G10 Financial MarketsG14 Information and Market EfficiencyG Financial EconomicsL13 Imperfect Markets
LiquidityMarket imperfectionsAsymmetric informationMarket microstructure
 
 
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In this article:
1 Introduction
2 Model
3 Perfect-Market Benchmark
4 Participation Costs
5 Transaction Costs
6 Asymmetric Information
7 Imperfect Competition
8 Funding Constraints
9 Search
10 Conclusion
Acknowledgments
References

Abstract

We survey the theoretical literature on market liquidity. The literature traces illiquidity, i.e., the lack of liquidity, to underlying market imperfections. We consider six main imperfections: participation costs, transaction costs, asymmetric information, imperfect competition, funding constraints, and search. We address three questions in the context of each imperfection: (a) how to measure illiquidity, (b) how illiquidity relates to underlying market imperfections and other asset characteristics, and (c) how illiquidity affects expected asset returns. We nest all six imperfections within a common, unified model, and use that model to organize the literature.

DOI:10.1561/0500000014
 
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Table of contents:
Introduction
Model
Perfect-Market Benchmark
Participation Costs
Transaction Costs
Asymmetric Information
Imperfect Competition
Funding Constraints
Search
Conclusions
References

Theories of Liquidity

Theories of Liquidity surveys the theoretical literature on market liquidity focusing on six main imperfections studied in that literature: participation costs, transaction costs, asymmetric information, imperfect competition, funding constraints, and search. The authors address three basic questions in the context of each imperfection: (a) how to measure illiquidity, i.e., the lack of liquidity, (b) how illiquidity relates to underlying market imperfections and other asset characteristics, and (c) how illiquidity affects expected asset returns. The theoretical literature on market liquidity often employs different modeling assumptions when studying different imperfections. Instead of surveying this literature in a descriptive manner, Theories of Liquidity uses a common, unified model to study all six imperfections that are considered, and for each imperfection addresses the three basic questions within that model. The model generates many of the key results shown in the literature. It also serves as a point of reference for surveying other results derived in different or more complicated settings, and for describing fruitful areas for future research. This survey is related to both market microstructure and asset pricing. It emphasizes fundamental market imperfections covered in the market microstructure literature, and examines how these relate to empirical measures of illiquidity used in that literature. It also examines how market imperfections affect expected asset returns - an asset-pricing exercise - and, in that sense, connects the two areas of research.

ISBN:978-1-60198-598-9 E-ISBN:978-1-60198-599-6 DOI:10.1561/9781601985996