Strategic Trading with Wealth Effects

Sergei Glebkin, Semyon Malamud and Alberto Teguia
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Sergei Glebkin: INSEAD
Semyon Malamud: Ecole Polytechnique Federale de Lausanne; Centre for Economic Policy Research (CEPR); Swiss Finance Institute
Alberto Teguia: University of British Columbia

No 23-116, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: We analyze asset prices and liquidity in an economy with large investors and many risky assets. The model allows for general investors' preferences and distributions of asset payoffs. We propose a constructive solution approach: solving for equilibrium reduces to solving nonlinear first-order ODE. We show that the equilibrium is unique under mild restrictions on payoffs and preferences. Liquidity risk is priced in equilibrium, leading to deviations from the consumption-CAPM. In stark contrast to a constant absolute risk aversion (CARA) benchmark, in a model with wealth effects, we obtain (1) illiquidity of risk-free assets (such as, e.g., Treasuries); (2) illiquidity contagion (a sell-off in one asset may have a price impact on assets with unrelated fundamentals) and asymmetry in cross-asset price impacts; (3) market liquidity may decrease in the number of traders and their wealth; and (4) in the presence of liquidity shortage, price impact may become negative giving rise to an illiquidity premium in asset prices; (5) safe assets are more illiquid because they have a larger price impact. In the presence of wealth heterogeneity, large traders trade more but also reduce their demands more. As a group, they account for a smaller fraction of orders compared to small investors. Fatter-tailed wealth distribution makes markets less liquid.

Keywords: Market Liquidity; Funding Liquidity; Price Impact; Strategic Trading; Wealth Effects (search for similar items in EconPapers)
JEL-codes: D21 G31 G32 G35 L11 (search for similar items in EconPapers)
Pages: 85 pages
Date: 2023-11
New Economics Papers: this item is included in nep-fdg and nep-mst
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