The goal of this paper is to study the relationship between liquidity in asset markets and economic fundamentals. To do so, we consider a setting in which firms have private information regarding the quality of their investment opportunities, which they must fund by issuing assets in financial markets. In this context, liquidity is defined as the ease of translating the future values of assets into current market prices. An illiquid economy is thus characterized by the fact that available assets are mispriced, in the sense that their price differs from the discounted value of the payments that they entail.
The main lesson that emerges from this perspective is that assets in the economy should not be assumed to be liquid or illiquid per se. Instead, the extent to which asset markets are liquid is determined in equilibrium by the leverage decisions of firms, which are in turn affected by the presence of asymmetric information and the underlying economic fundamentals. Lack of liquidity is therefore an equilibrium result that may not must appear.
The theoretical model predicts that liquidity, investment, and the variance of leverage decisions across firms should all be positively correlated with economic growth. I compare these theoretical predictions with evidence from the US corporate bond market: in doing this, I interpret the dispersion in the yields at maturity on newly issued publicly traded debt as a measure of liquidity consistent with the model.
The model sheds light on two stylized facts that I emphasize in the US corporate bond market: the positive relationship between GDP growth and the dispersion in the yields at maturity on newly issued publicly traded debt; the positive relationship between GDP growth and the dispersion in ratings on publicly traded bonds & a measure of the variance of leverage decisions undertaken by private firms. To my knowledge, this is the first paper to rationalize these facts introducing yields dispersion as a macroeconomically relevant measure of liquidity.
I consider an economy where privately informed entrepreneurs finance their investment through the issue of bonds, subject to the possibility of default. There are two distinctive features of this economy. The first is that entrepreneurs have private information about the productivity of the investment opportunity they own.
The second is that entrepreneurs choose how many bonds they issue, hence selecting the size of their investment and the probability and extent of default on their bonds. This seems an appealing feature because in reality firms actively manage their leverage. Moreover this is also a natural assumption: since Leland et al. (1977) and Myers et al. (1984), it was observed that firms may strategically use their leverage decision, which is observable and affects the probability of default on their bonds, to disclose private information.
Consumers lend funds to entrepreneurs by purchasing bonds in competive markets. They can only distinguish one firm from the other on the basis of its leverage, i.e. the number of bonds a firm issues. Capital markets are consistently organized so that all bonds issued by firms undertaking the same leverage decision are traded in the same market. The price of a given bond thus reflects the information consumers extract in equilibrium about the mix of good and bad entrepreneurs undertaking that specific leverage level.
