Financial Claustrophobia: Asset Pricing in Illiquid Markets

31 Pages Posted: 20 Apr 2004 Last revised: 14 Dec 2022

See all articles by Francis A. Longstaff

Francis A. Longstaff

University of California, Los Angeles (UCLA) - Finance Area

Date Written: April 2004

Abstract

There are many examples of markets where an agent who wants to get out of an investment position quickly may find himself trapped and forced to remain in that position because of a lack of liquidity. What are the asset-pricing implications when agents cannot always buy and sell assets immediately? We study this issue in a multi-asset exchange economy with heterogeneous agents. In this model, agents can trade initially, but then cannot trade again until after a trading blackout' period. The more liquid the market, the sooner agents can trade again. Faced with illiquidity, agents abandon diversification and choose highly polarized portfolios. Risky assets are held primarily by the less-patient short-horizon agents in the economy. Polarization causes the usual risk-return tradeo. to break down and an asset's price may have more to do with the demographics of who owns it than with the riskiness of its cash flows. Risky assets are generally more valuable in an illiquid market than in a liquid market. Market illiquidity can also have large effects on the equity premium.

Suggested Citation

Longstaff, Francis A., Financial Claustrophobia: Asset Pricing in Illiquid Markets (April 2004). NBER Working Paper No. w10411, Available at SSRN: https://ssrn.com/abstract=528992

Francis A. Longstaff (Contact Author)

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-2218 (Phone)
310-206-5455 (Fax)

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