Essays on liquidity in financial markets

Chitrupa Sudarshan Fernando, University of Pennsylvania


A theory of the value of liquidity is developed and its implications investigated for various aspects of financial market behavior. The linkage between the value of liquidity and liquidity premia on asset prices is explicitly developed and forms the basis for much of the analysis presented. The results offer potentially new insights into the impact of various structural and informational features of financial markets, on asset prices and investor welfare. This dissertation consists of four essays. In the first essay we develop the benchmark model in the context of which closed form expressions are derived for liquidity premia in different market settings. A fundamental result--that liquidity is an important determinant of asset prices--is established and the link between liquidity, volume and asset prices is demonstrated. In the second essay we generalize the benchmark model to include transaction costs and market makers. First, we demonstrate that transaction costs reduce asset prices through their dampening effect on liquidity. Second, we establish the manner in which transaction costs are endogenously determined by the actions of market makers. Third, we demonstrate the positive impact of market stabilization by market makers, in terms of enhanced asset prices. Finally, we show that public information releases could reduce investor welfare by lowering stock prices. In the third essay we develop a two-period noisy rational expectations model with endogenous liquidity trading. The results demonstrate that stocks characterized by insider trading would be priced lower than otherwise identical stocks whose trades are liquidity driven. We also extend previous work by demonstrating how the observed decline of asset prices obtains in conjunction with the collapse of financial markets. The fourth essay focuses on a recent phenomenon in the Eurobond market--the collapse of the Perpetual Floating Rate Note--to show how systemic liquidity shocks cause market collapse. We argue that the theoretical framework developed in this dissertation is closely compatible with the breakdown of the secondary market for these notes and the steep decline in prices that accompanied it.

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Recommended Citation

Fernando, Chitrupa Sudarshan, "Essays on liquidity in financial markets" (1991). Dissertations available from ProQuest. AAI9211933.