Financial markets are susceptible to periods of market breakdown. Such periods are often preceded by bad news about fundamentals and involve: a large decrease in trade volume and market prices that diverge from fundamentals. In this paper, we propose a mechanism to help understand such phenomenon.
The model takes place in a dynamic economy with fully rational, risk-neutral agents who share a common-prior. There is a single indivisible asset in the economy that delivers cashflows to the owner of the asset. The cashflows depend on the asset’s type, which is privately known by the current owner. As time passes, (i) potential buyers arrive and make offers to the asset owner, (ii) stochastic information about the asset’s type is gradually revealed to the market by a Brownian diffusion process and (iii) the asset owner is subject to an observable liquidity shock.
Liquidity shocks arrive randomly according to a Poisson process and increase the rate at which an owner of the asset discounts future payoffs generating a potential gain from trade. The owner of an asset is not forced to sell upon the arrival of a liquidity shock, but she is more eager to do so. In this setting, a trader’s value for the asset depends not only on her beliefs about the asset type but also on her expectations about future liquidity in the market. Thus, a buyer’s value for the asset arises endogenously through the structure of the equilibrium.
We characterize the equilibrium through a system of differential equations and boundary conditions. In equilibrium, an owner who is not liquidity constrained never sells. When the owner is constrained, trading behavior can be characterized by three distinct regions: (1) the market is liquid when the market’s beliefs about the quality of the asset are favorable, constrained sellers are able to trade quickly at “fair” prices; (2) a sell-off region when the market is very pessimistic, an owner hit by a shock in this region is forced to either sell at rock-bottom prices or hold out; (3) a no-trade region where both sides of the market wait for news until either good news restores confidence to (1) or bad news forces (2).
The no-trade region leads to an inefficient allocation of the asset. This makes liquidation costly for a seller because it requires inefficient delay before the asset is transferred. Buyers correctly anticipate these liquidation costs and therefore the asset trades at prices below it’s fundamental value. Asset prices decrease and the inefficiency increases with the arrival rate of shocks because traders liquidate (and incur the cost from doing so) more frequently. The occurs despite the fact that the fundamental value of the asset remains constant. As the arrival rate of liquidity shocks goes to zero, asset prices converge to fundamental values.
Download
Asset Trading, News, and Liquidity in Markets with Asymmetric Information
