Dynamic liquidity in endowment economies

Johnson, T (2005) Dynamic liquidity in endowment economies. Working Paper. London Business School IFA Working Paper.

Abstract

While recent research has examined the asset pricing implications of systematic liquidity risk, a more basic question remains: Why does market liquidity change over time? Economywide fluctuations in asymmetric information, search costs, and credit conditions all may play a part. This paper highlights another potential explanation: changes in the willingness of agents to accommodate perturbations to their equilibrium portfolio holdings. I propose a natural measure of this flexibility essentially a shadow elasticity which, like a shadow price, is well defined whether or not trade actually occurs in the economy. This quantity characterizes the price impact or bid/ask spread that a small trader would experience, and is an endogenous function for the underlying state variables in the economy. I compute the function for some tractable example models and uncover a rich variety of predictions about liquidity dynamics that, in some cases, appear consistent with both the levels and covariations observed in the data. The results have important implications for the pricing and hedging of liquidity risk.