Abstract

The presence of information asymmetry increases the probability that a potential predator will provide liquidity rather than engaging in predatory trading during liquidation by a distressed trader. More information asymmetry is associated with lower expected losses from liquidation for the distressed trader in illiquid markets. There is a negative correlation between the degree of information asymmetry and the returns from predatory trading, which is consistent with empirical findings. These results imply that strategic traders are more likely to stabilize markets by providing liquidity when information is asymmetric. These findings highlight a cost associated with disclosure and can explain the documented rarity of illiquidity episodes in financial markets.

Abstract

I present a model of belief formation in asset markets based on the law of small numbers heuristic (Tversky and Kahneman, 1971) and study its implications for both asset prices and portfolio choices. This heuristic is the belief that small samples should be representative of the population, which leads to hysteresis in beliefs. The following properties arise in a in a continuous time Lucas Orchard in which a subset of investors believes in the law of small numbers: (1) asymmetric v-shaped trading patterns; (2) the disposition effect; (3) momentum; (4) reversal. Momentum crashes occur, and the reversal of momentum returns is slower when portfolios are formed with larger assets. Belief in the law of small numbers implies predictable patterns in beliefs. I show that the risk associated with the momentum strategy can be managed by accounting for this predictability.

(with Sergei Glebking and Semyon Malamud)

Abstract

We derive closed form expressions for equilibrium asset prices and liquidity in an economy populated by a finite number of large, strategic, risk averse investors. The model allows for arbitrary risk preferences, any number of assets, and an arbitrary distribution of asset payoffs. In equilibrium, assets are priced according to the standard consumption Euler equation plus a correction term accounting for market illiquidity (price impact), linked to an endogenous measure of systemic risk that puts a large weight on low consumption states. Wealth effects imply that price impact is generally asymmetric, which leads to the emergence of endogenous systemic assets: That is, assets whose sell-off triggers large moves in all security prices. Market liquidity is non-monotonic in funding liquidity and may decrease in the number of investors. In the presence of liquidity shortage, price impact becomes negative and gives rise to an illiquidity premium in asset prices.

Abstract