Essays on liquidity, endogeneity of central banking and portfolio selection

Lixin Huang, University of Pennsylvania

Abstract

Liquidity, efficiency and bailouts. In illiquid markets asset prices can be below their expected values. What is “liquidity” and where does it come from? What determines the “liquidity discount” to expected asset values? We present a general equilibrium model in which some agents opportunistically invest in certain kinds of assets, which can be used to purchase projects or securities of other agents who subsequently may seek to sell them. These agents, who stand ready to purchase the projects or securities of other agents, are supplying liquidity. The market price of such claims depends on the supply of liquidity, which is determined in general equilibrium, not just on information about payoffs. While private liquidity provision is socially beneficial since it allows valuable reallocations, it is also socially costly since liquidity suppliers could have made more efficient investments, ex ante. As a result, there is a potential role for the government to supply liquidity by issuing government securities, backed by tax revenue. The welfare properties of private liquidity provision and of government liquidity provision are analyzed. The analysis is extended to analyze the role of the government in recapitalizing or “bailing out” the banking system. Bank panics and the endogeneity of central banking. Central banking is intimately related to liquidity provision to banks during times of crisis, the lender-of-last-resort function. This activity arose endogenously in certain banking systems. Depositors lack full information about the value of bank assets so that during macroeconomic downturns they monitor their banks by withdrawing in a banking panic. The likelihood of panics depends on the industrial organization of the banking system. Banking systems with many small, undiversified banks, are prone to panics and failures, unlike systems with a few big banks that are heavily branched and well diversified. Systems of many small banks are more efficient if the banks form coalitions during times of crisis. We provide conditions under which the industrial organization of banking leads to incentive compatible state contingent bank coalition formation. Such coalitions issue money that is a kind of deposit insurance and examine and supervise banks. Bank coalitions of small banks, however, cannot replicate the efficiency of a system of big banks. Portfolio selection with return predictability and periodically observable state variables. In this paper we consider the optimal portfolio selection problem for a CRRA investor who derives utility from his terminal wealth. The stock return is predictable and dependent on a latent state variable, which is observable only periodically. We derive the investor's value function in an explicit form and show that the problem amounts to solving for time-varying functions from a system of ODEs which have a closed form solution in the one-dimensional case. We find that continuously observing the state variable is important to the investor and sporadic observation results in a significant utility loss even when he can observe it frequently. The value of the information on the state variable increases as the investment horizon increases, as the risk aversion decreases, and as the precision of the prior belief declines. In addition, we find that the precision of the prior has a large impact on the optimal trading strategy in the stock. Moreover, the stock trading strategy is insensitive to horizon changes. We also show that ignoring predictability is costly to the investor even when he cannot always observe the state variable.

Subject Area

Finance|Banking

Recommended Citation

Huang, Lixin, "Essays on liquidity, endogeneity of central banking and portfolio selection" (2002). Dissertations available from ProQuest. AAI3054953.
https://repository.upenn.edu/dissertations/AAI3054953

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