Differences of Opinion, Endogenous Liquidity, and Asset Prices

Emilio Osambela

The Review of Financial Studies, 2015, vol. 28, issue 7, 1914-1959

Abstract: This paper studies how investors' differences of opinion affect liquidity and asset prices. In our economy, excessively optimistic investors are subject to an endogenous funding constraint that prevents default due to ex-ante-limited commitment. When the funding constraint binds, optimists use their savings to increase their consumption share, deterring default. This allows them to place speculative trades, increasing market liquidity. Their losses on these trades make them prone to default, leading to a renewed binding of the funding constraint. This feedback between funding illiquidity, disagreement, and market liquidity is consistent with several empirical features of liquidity and financial asset prices.

Date: 2015
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