Liquidity and Market Incompleteness

This note shows that according to Lipmann and McCall´s (1986) operational definition of liquidity, incomplete markets are a necessary condition for illiquidity.Liquidity, insurance

Liquidity as an Insurance Problem

Risk-averse individuals wish that assets concentrate their payoffs in states of high marginal value (that is, highly likely or low endowment states). An asset or portfolio may fail to do so, by having payoffs uncorrelated to its owner needs or, even worse, by having them inversely related. The latter, which we call tier 1 illiquidity, is shown to occur in non-Walrasian markets (where a trade involves bargaining) and in incomplete Walrasian markets where optimal trading strategies are non trivial. In both cases, the high valuation of the trader biases the equilibrium price against him. The former, which we call tier 2 illiquidity, is shown to arise when individual shocks are privately observed, because moral hazard prevents contracting on them. Diamond and Dybvig (1983) and Holmström and Tirole (1998) present prominent examples of tier 2 illiquidity. However, a self-insurance model is offered to argue that the importance of this type of illiquidity is limited from a welfare perspective, provided individuals are patient enough and can trade in a perfectly competitive, complete—except for individual-level uncertainty— set of asset markets. This article characterizes an asset’s liquidity as the degree of insurance it provides, thereby identifying the basic economic problem behind liquidity as one of the familiar risk-sharing kind. It also shows, by means of examples, that the problem arises when asset markets are imperfectly competitive, incomplete, or both.Liquidity, insurance

Beyond Earthquakes: The New Directions of Expected Utility Theory

Over the past two decades or so, an enormous amount of work has been done to improve the Expected Utility model. Two areas have attracted major attention: the possibility of describing unforeseen contingencies and the need to accommodate the kind of behavior referred to in Ellsberg’s paradox. This essay surveys both.

Speculation in Financial Markets: A Survey

This survey covers the microeconomic theory of speculation in financial markets, since the development of the economics of uncertainty. It starts with a description of Walrasian exchange economies, both in general equilibrium –the Arrow-Debreu model and its extensions– and in partial equilibrium. Speculation, it is explained, is an incomplete-market phenomenon. It proceeds by analyzing more general voluntary trade environments, with a focus on whether or not differences in information are a valid source for belief heterogeneity. The role of common priors in the no-trade theorem is discussed. Finally, heterogeneous priors models are considered.

On the Limits to Speculation in Centralized versus Decentralized Market Regimes

Speculation creates an adverse selection cost for utility traders, who will choose not to trade if this cost exceeds the benefits of using the asset market. However, if they do not participate, the market collapses, since private information alone is not sufficient to create a motive for trade. Therefore, there is a limit to the amount of speculative transactions that a given market can support. We compare this limit in decentralized versus centralized market regimes, finding that the centralized regime is more prone to speculation than the decentralized one: the transaction fees charged by an intermediary diminish the individual return to information, so that for a fixed value of trading, more speculative transactions can be supported. The analysis also suggests a reason for the existence of intermediaries in financial markets.Speculation, adverse selection, centralized markets

Liquidity and Financial Markets - Introduction

Liquidity, trading activity, VaR, best practices

Liquidity and the Simple Industrial Organization of Stock Exchanges

It is usually thought that network externalities, which are inherent to liquidity, make it desirable to concentrate transactions in one stock exchange. This paper shows that when the value of liquidity stems from the ability of potentially reach as many traders as possible, the market is integrated when every broker meets every other broker in at least one exchange. Thus, fragmentation is not about trades being executed in different exchanges but of connectedness among brokers. An implication of this distinction is that in an integrated market the network externality created by liquidity becomes pecuniary and the optimal number of exchanges depends only on the shape of the (physical) technology to execute trades—whether it exhibits increasing, constant or decreasing returns to scale—as in any standard industry. We characterize the planner’s allocation and compare it with that reached by a monopoly. It is shown that when exchanges are natural monopolies a particular ownership structure of the exchange and allocation of voting rights over the exchange fee achieve the planner’s optimum. With decreasing returns to scale the Walrasian allocation is eficient, provided that the market is integrated. Nevertheless, with few exchanges the price-taking assumption is suspect. If exchanges are not price takers, there are many other equilibria, all of them ineficient. Moreover, there are reasons to doubt that the market will become integrated. Fragmentation softens price competition between exchanges and may help a monopolist exchange to erect a barrier to entry even when he has no cost advantage.Brokerage, exchange fee, fragmentation, liquidity, network externality

Two Hundred Years of Economic Growth: Latin America at its Bicentennial Celebration

On December 2010, five research teams gathered in Santiago, Chile, to discuss the growth experiences of Argentina, Chile, Colombia, Mexico and Venezuela since independence from Spain was declared in 1810. The five teams answered an invitation from the editors of the Latin American Journal of Economics to explain why these countries’ growth experiences lag so far behind those of the developed world, and at the same time, why their trajectories have been so dissimilar. This paper serves as an introduction to the special issue, characterizing the patterns of growth in Latin America, and discussing the teams’ answers.Growth, Latin America, bicentenary

Ignorance, Fixed Costs, and the Stock-Market Participation Puzzle

While the existence of fixed costs in entering asset markets is the leading rationalization of the “participation puzzle” —the fact that most households do not hold stocks, despite the diversification gains and the significant risk-premium involved—, most motivations of these fixed costs are as incompatible with conventional portfolio theory as the non participation itself. Nevertheless, we believe that these motivations are empirically correct, and thus we are forced to explore alternatives to conventional portfolio theory. We find in Choquet expected utility theory a tool that is better equipped to deal with more complex forms of ignorance than expected utility is. Within such model, we are able to express the idea that staying out of the market may be a rational response to the own ignorance. Within a Probit model for the 2001 Survey of Consumer Finances, we show suggestive evidence in its favor.Non additive beliefs, ambiguity, ignorance, asset market participation

Beyond Earthquakes: The New Directions of Expected Utility Theory

Over the past two decades, an enormous amount of work has been done to improve the Expected Utility model. Two areas have attracted major attention: the possibility of describing unforeseen contingencies and the need to accomodate the kind of behavior refAmbiguity, unawareness, unforeseen contingencies, expected utility