Paper millionaires: How valuable is stock to a stockholder who is restricted from selling it?

Many firms have stockholders who face severe restrictions on their ability to sell their shares and diversify the risk of their personal wealth. We study the costs of these liquidity restrictions on stockholders using a continuous-time portfolio choice framework. These restrictions have major effects on the optimal investment and consumption strategies because of the need to hedge the illiquid stock position and smooth consumption in anticipation of the eventual lapse of the restrictions. These results provide a number of important insights about the effects of illiquidity in financial markets.

Free-riding on liquidity

Do financial market participants free-ride on liquidity? To address this question, we construct a dynamic general equilibrium model where agents face idiosyncratic preference and technology shocks. A secondary financial market allows agents to adjust their portfolio of liquid and illiquid assets in response to these shocks. The opportunity to do so reduces the demand for the liquid asset and, hence, its value. The optimal policy response is to restrict (but not eliminate) access to the secondary financial market. The reason for this result is that the portfolio choice exhibits a pecuniary externality: An agent does not take into account that by holding more of the liquid asset, he not only acquires additional insurance but also marginally increases the value of the liquid asset which improves insurance to other market participants.Monetary policy, liquidity, financial markets

Open-end real estate funds : danger or diamond?

Both banks and open end real estate funds effectuate liquidity transformation in large amounts and high scales. Because of this similarity the latter should be analyzed using the same methodologies as usually applied for banks. We show that the work in the tradition of Diamond and Dybvig (1983), especially Allen and Gale (1998) and Diamond and Rajan (2001), provides an applicable theoretical framework. We used this as the basis for our model for open end real estate funds. We then examined the usefulness of the modeling structure in analyzing open end real estate funds. First, we could show that withdrawing of capital resulting in a run is not always inefficient. Instead, withdrawing can as well be referred to the situation where the low return of an open end fund unit in comparison to other opportunities makes, (partial) withdrawal viewed from the risk-sharing perspective optimal. Even with costly liquidation, this result will hold, though we will have deadweight losses in such a situation. Second, introducing a secondary market in our model does, not in general, resolve the problem of deadweight losses associated with foreclosure. If assets are sold during a run, we do not only have a transfer of value but it can also create an economic cost. Because funds are forced to liquidate the illiquid asset in order to fulfill their obligations, the price of the real estate asset is forced down making the crisis worse. Rather than providing insurance, such that investors receive a transfer in negative outcomes, the secondary market does the opposite. It provides a negative insurance instead. Third, our model proves that the open end structure provides a monitoring function which serves as an efficient instrument to discipline the funds management. Therefore, we argue that an open end structure can represent a more adequate solution to securitize real estate or other illiquid assets. Instead of transforming open end in closed end structures, fund runs should be accepted as a normal phenomenon to clear the market from funds with mismanagement

Liquidity Risk and Monetary Policy

This paper provides a framework to analyse emergency liquidity assistance of central banks on financial markets in response to aggregate and idiosyncratic liquidity shocks. The model combines the microeconomic view of liquidity as the ability to sell assets quickly and at low costs and the macroeconomic view of liquidity as a medium of exchange that influences the aggregate price level of goods. The central bank faces a trade-off between limiting the negative output effects of dramatic asset price declines and more inflation. Furthermore, the anticipation of central bank intervention causes a moral hazard effect with investors. This gives rise to the possibility of an optimal monetary policy under commitment

Pricing Illiquid Assets

The present paper investigates the portfolio allocation decisions of an investor with infinite horizon when available financial assets differ in their degrees of liquidity. A model with risk neutral agents allows us to endogenously determine the liquidity premium. With risk averse agents, we develop a nontrivial portfolio allocation problem, which enables us to calculate the demand for an illiquid asset for any given yield premium. We calibrate and numerically simulate both models. Reasonable parameter values imply a liquidity premium of 1.7% for the risk neutral case. In the portfolio allocation problem we find that a reasonable amount of illiquidity can cause a substantial drop of demand for the asset. We are also able to calculate the price discount at which an agent would be indifferent between immediate sale and waiting for a buyer with a fundamentally justified price.

Life-Cycle Asset Allocation with Annuity Markets: Is Longevity Insurance a Good Deal?

We derive the optimal portfolio choice over the life-cycle for households facing labor income, capital market, and mortality risk. In addition to stocks and bonds, households also have access to incomplete annuity markets offering a hedge against mortality risk. We show that a considerable fraction of wealth should be annuitized to skim the return enhancing mortality credit. The remaining liquid wealth (stocks and bonds) is used to hedge labor income risk during work life, to earn the equity premium, and to ensure estate for the heirs. Furthermore, we assess the importance of common explanations for limited participation in annuity markets.

Credit derivatives, the liquidity of bank assets and banking stability

The emerging markets for credit derivatives have improved the liquidity of bank assets by providing banks with various new possibilities for selling and hedging their risks. This paper examines the consequences for banking stability. In a simple model where liquidation of bank assets is costly, we show that increased asset liquidity benefits stability by encouraging a representative bank to reduce the risks on its balance sheet. Stability is further enhanced because the bank can now liquidate assets in a crisis more easily. However, we find that these stability effects are counteracted by increased risk-taking by the bank. Overall, stability actually falls because the improved possibilities for liquidating assets in a crisis make a crisis less costly for the bank. The bank therefore takes on an amount of risk that more than offsets the initial positive impact on stability

Outside versus inside bonds: a Modigliani-Miller type result for liquidity constrained economies

When agents are liquidity constrained, two options exist - sell assets or borrow. We compare the allocations arising in two economies: in one, agents can sell government bonds (outside bonds) and in the other they can borrow (issue inside bonds). All transactions are voluntary, implying no taxation or forced redemption of private debt. We show that any allocation in the economy with inside bonds can be replicated in the economy with outside bonds but that the converse is not true. However, the optimal policy in each economy makes the allocations equivalent.Financial markets ; Bond market ; Liquidity (Economics)