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Free-riding on Liquidity


Berentsen, Aleksander; Huber, Samuel; Marchesiani, Alessandro (2011). Free-riding on Liquidity. Working paper series / Department of Economics No. 32, University of Zurich.

Abstract

Do financial market participants free-ride on liquidity? To address this question, we construct a dynamic general equilibrium model where agents face idiosyncratic preference and technology shocks. A secondary financial market allows agents to adjust their portfolio of liquid and illiquid assets in response to these shocks. The opportunity to do so reduces the demand for the liquid asset and, hence, its value. The optimal policy response is to restrict (but not eliminate) access to the secondary financial market. The reason for this result is that the portfolio choice exhibits a pecuniary externality: An agent does not take into account that by holding more of the liquid asset, he not only acquires additional insurance but also marginally increases the value of the liquid asset which improves insurance to other market participants.

Do financial market participants free-ride on liquidity? To address this question, we construct a dynamic general equilibrium model where agents face idiosyncratic preference and technology shocks. A secondary financial market allows agents to adjust their portfolio of liquid and illiquid assets in response to these shocks. The opportunity to do so reduces the demand for the liquid asset and, hence, its value. The optimal policy response is to restrict (but not eliminate) access to the secondary financial market. The reason for this result is that the portfolio choice exhibits a pecuniary externality: An agent does not take into account that by holding more of the liquid asset, he not only acquires additional insurance but also marginally increases the value of the liquid asset which improves insurance to other market participants.

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Additional indexing

Item Type:Working Paper
Communities & Collections:03 Faculty of Economics > Department of Economics
Working Paper Series > Department of Economics
Dewey Decimal Classification:330 Economics
JEL Classification:E52, E58, E59
Language:English
Date:September 2011
Deposited On:25 Nov 2011 10:13
Last Modified:05 Apr 2016 15:08
Series Name:Working paper series / Department of Economics
ISSN:1664-7041
Official URL:http://www.econ.uzh.ch/wp.html
Permanent URL: https://doi.org/10.5167/uzh-51536

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