Liquidity Shocks in Over-the-Counter Markets

Abstract

This dissertation addresses liquidity and aggregate liquidity shocks in over-the-counter (OTC) markets. The topic was inspired by the pioneering work of Duffie, Gârleanu, and Pedersen (2005, 2007), who initiated a new strand of literature about asset pricing in OTC markets. This thesis completes the aggregate liquidity shock model of Duffie, Gârleanu, and Pedersen (2007), since it turned out to be imperfect.

The thesis starts with an introduction into the basic search and bargaining model by Duffie et al. (2005) for asset pricing in an illiquid OTC market. Illiquidity is modeled with search frictions, which imply that trade does not happen instantly. Upon finding a trading partner, asset prices are directly bargained between those agents. This model forms the basis for the aggregate liquidity shock model by Duffie et al. (2007). Aggregate liquidity shocks are associated with a sudden shift in agents’ preferences towards asset holding, affecting a large fraction of investors simultaneously. Several investors experience a sudden decrease in their liquidity, leading to a forced withdrawal of assets: The market is hit by a selling pressure.

This thesis presents an analytical solution method for the aggregate liquidity shock model of Duffie et al. (2007) and derives a semi-analytical solution for asset prices. Additionally, it shows how to complete the aggregate liquidity shock model of Duffie et al. (2007), since it turned out to be imperfect.