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Liquidity misallocation in an over-the-counter market

Zhang, Shengxing (2018) Liquidity misallocation in an over-the-counter market. Journal of Economic Theory, 174. pp. 16-56. ISSN 0022-0531

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Identification Number: 10.1016/j.jet.2017.11.008

Abstract

To understand the illiquidity of the over-the-counter market when dealers and traders are in long-term relationships, I develop a framework to study the endogenous liquidity distortions resulting from the profit-maximizing, screening behavior of dealers. The dealer offers the trading mechanism contingent on the aggregate history of his customers summarized by the asset allocation. The equilibrium distortion is type dependent: trade with small surplus breaks down; trade with intermediate surplus may be delayed; trade with large surplus is carried out with a large bid/ask spread but without delay. Because of dealers' limited commitment, the distortions become more severe when the valuation shock is frequent, the valuation dispersion is large or the matching friction to form new relationships is large. Calibrating the model and running a horse race between matching efficiency, trading speed and relationship stability, I found that the liquidity disruption in the market during the recent financial crisis is more consistent with declining matching efficiency of forming trading relationsh

Item Type: Article
Official URL: https://www.journals.elsevier.com/journal-of-econo...
Additional Information: © 2017 Elsevier Inc.
Subjects: H Social Sciences > HC Economic History and Conditions
H Social Sciences > HG Finance
JEL classification: D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D82 - Asymmetric and Private Information
D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D83 - Search; Learning; Information and Knowledge; Communication; Belief
G - Financial Economics > G1 - General Financial Markets
Sets: Departments > Economics
Collections > Economists Online
Date Deposited: 20 Feb 2018 16:03
Last Modified: 20 Feb 2018 16:10
URI: http://eprints.lse.ac.uk/id/eprint/86800

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