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The price is not always right:

the effects of liquidity costs and constraints on prices and allocations

Andr Levy

A thesis in fulfilment of the requirements for the degree of

Doctor of Philosophy

School of Banking and Finance

UNSW Business School

November 2015

Originality Statement
I hereby declare that this submission is my own work and to the best of my
knowledge it contains no materials previously published or written by another person,
or substantial proportions of material which have been accepted for the award of any
other degree or diploma at UNSW or any other educational institution, except where
due acknowledgement is made in the thesis. Any contribution made to the research by
others, with whom I have worked at UNSW or elsewhere, is explicitly acknowledged in
the thesis. I also declare that the intellectual content of this thesis is the product of my
own work, except to the extent that assistance from others in the project's design and
conception or in style, presentation and linguistic expression is acknowledged.

Signed ..............
Date ..............


I am thankful for the financial support of the Sasakawa Foundation though their
Young Leaders Fellow Program. Funding towards our research was also provided by
the Australian Research Council (ARC).
I would like to thank the Australian Prudential Regulation Authority for their
financial and moral support in my PhD candidacy.
I am also thankful for the many opportunities that the Australian School of Business
at the University of New South Wales has offered me in both participating in seminars
and presenting our research at conferences.
I thank Ashley Coull, Stephanie Osborne and particularly Shirley Webster for easing
my pain in getting through the paperwork, often fixing my mistakes, and always with a
soothing smile.
I am most thankful for Professor David Feldmans guidance and support, who was
always open and available to provide valuable feedback.
I am also most thankful to Professor Peter Pham for going far beyond the call of duty
in helping me to navigate and comply with the universitys rules and regulations.
Needless to say, I am deeply indebted for the unwavering guidance and support of
my thesis supervisor, Professor Peter Swan AM FASSA, with whom I have enjoyed
many discussions on the topics of my research. Truly, I would not have made it without
his wholehearted support.
Last, but definitely not least, I would like to acknowledge the infinite patience and
confidence of my wife Leila in this long endeavour.


The main argument of this thesis is that price and value are not always the same. I
investigate the effects of impediments to trade and funding on prices and allocations in
three different settings.
In the first setting, I examine a market with transaction costs and short selling
constraints. I find that, when transaction costs differ across assets, funding constraints
create a shadow price for liquidity. Thus, it is the combination of asset and liability
illiquidity that generate illiquidity premiums. My first main chapter sheds light on the
long standing equity premium puzzle.
In the second setting, I show that, in a market with a small number of informed,
uninformed and noise traders, the demand for financial assets can be nonlinear on
prices. The theoretical literature thus far generally assumes these to be linear, or makes
assumptions that lead to linearity. I take a departure from those assumptions,
reconciling the model with the empirical literature, which has identified nonlinearities
in a variety of settings.
Finally, I demonstrate that financial access instability produces cycles of financial
bubbles and bursts. In this setting, I examine an exchange economy with three classes of
participants: lenders, borrowers and workers. I show that, if workers access to credit is
unstable, their entrance and exit into the financial market will generate price
fluctuations even when there are no exogenous risks to the economy. Further, and most
importantly, I demonstrate how their entry and exit is endogenously generated by a


coordination failure amongst borrowers, with whom the new entrants compete for credit
and investments.
My results in this thesis point to the understanding that when liquidity is a scarce
resource, much like any other scarce resource, it commands a price. Such price of
liquidity is embedded in traded prices in the markets in which transactions and funding
are not costless, creating deviations away from the intrinsic value of traded assets.
Illiquidity can then substantially impair the market price system from optimally
allocating the economys resources. The results in this thesis thus have substantial
implications in public policy as well as in management compensation incentives.

Table of Contents
Originality Statement ................................................................................................................ ii
Acknowledgements .................................................................................................................. iii
Abstract .................................................................................................................................... iv

Introduction............................................................................................................. 1

Linearity and Nonlinearity of Limit Orders in Thin Markets ...................................... 3


Perfectly Rational Financial Bubbles ........................................................................... 5

Wither Equity Premium Puzzle? .......................................................................... 9


Introduction ................................................................................................................ 10


The Benchmark Case: Perfect Competition ............................................................... 17


Quadratic Transaction Costs ...................................................................................... 19


Imperfect Competition (Oligopsony) ......................................................................... 20


Illiquid Security with a Liquid Substitute .................................................................. 21


Model Calibrations ..................................................................................................... 29


Conclusions ................................................................................................................ 40

Appendix ................................................................................................................................. 41

Linearity and Nonlinearity of Limit Orders in Thin Markets ......................... 45


Introduction ................................................................................................................ 47


Literature .................................................................................................................... 48


Model ......................................................................................................................... 52


Conclusions ................................................................................................................ 57

Appendix A ............................................................................................................................. 59
Appendix B ............................................................................................................................. 68

Perfectly Rational Financial Bubbles.................................................................. 75


Introduction ................................................................................................................ 76


Capturing a Bubble .................................................................................................... 78


Literature .................................................................................................................... 79


Model ......................................................................................................................... 82


Results ........................................................................................................................ 88


Interpretation .............................................................................................................. 90


Prudential Regulation ................................................................................................. 91


Conclusions ................................................................................................................ 91

References ...................................................................................................................... 93

1 Introduction

The main argument of this thesis is that liquidity is a scarce resource and, as any
scarce resource, it commands a price. Thus, when markets are not perfectly liquid, when
there are costs or impediments to trade and finances, prices reflect not only the
dividends they produce, but also the liquidity they provide. In other words, the market
values assets not only as means of production but also as means of exchange.
This has significant impacts on the market price systems ability to optimally allocate
resources in the economy. When liquidity is heterogeneous across assets, investments
may not concentrate in the most productive assets, and flock towards the most liquid.
This is essentially the core engine of financial bubbles, which typically create incentives
for entrepreneurs to make malinvestments.
Skewed incentives may also be present even when a bubble is not present. Corporate
executives remunerated with stock options or holdings may a have an incentive to
concentrate efforts in raising stock performance via improved liquidity rather than via
company productivity.

The finance literature has mixed results in explaining the impact of liquidity in asset
prices. Divided in three separate chapters, I offer three models in which illiquidity
impacts equilibrium prices.
Chapter 2. Wither Equity Premium Puzzle
Chapter 3. Linearity and Nonlinearity of Limit orders in Thin Markets
Chapter 4. Perfectly Rational Financial Bubbles
Chapter 2 attempts to explain the equity premium puzzle, a long standing conundrum
in the finance literature. While previous attempts in the literature have had limited
success, I show that a liquidity premium is attained by combining impediments to
funding liquidity as well as to market liquidity. Intuitively, if traders face transaction
costs, but can fund their losses limitlessly, they can simply wait indefinitely for optimal
trading conditions to arise. Thus, while a bid-ask spread will be present, the shift from
the equilibrium mid-price in a perfectly liquid market is negligible. This has been
shown, though not always argued in this way, by a number of authors, and most
prominently by Constantinides (1986).
On the other hand, if they face no constraints or costs in funding, or equivalently on
short selling, they will freely shift their holdings between securities without ever
coming to a funding bind. Thus, funding constraints become immaterial, and again
equilibrium prices again remain undisturbed. What I show in this chapter is that one
may generate a liquidity premium by combining funding and market illiquidity. Again,
this is intuitive. As long as traders are free to trade their way out through at least one

side of their balance sheet, they can always make illiquidity practically immaterial, and
thus keeping equilibrium prices unchanged. However, liquidity becomes a scarce
commodity with a substantial shadow price if traders face impediments both through
their assets and liabilities. Thence, a liquidity premium emerges in this setting, and the
price of a security is no longer purely a reflection of its intrinsic value.

1.1 Linearity and Nonlinearity of Limit Orders in Thin Markets

The main result from Chapter 3 is a market microstructure model of securities
trading that fits the empirical literature, in which it has been observed that the price
impact of traded volume is nonlinear. Heretofore the theoretical literature, following
Kyle (1985) and Kyle (1989) typically assumed price impact to be linear, and thus
inconsistent with empirical evidence. I provide a model that is consistent.
1. I first show that two of the assumptions in Kyle (1989) paper, which has
been the cornerstone for much of the market microstructure literature, are
logically equivalent and therefore redundant;
2. I then solve a problem Kyle left unresolved by demonstrating that the two
assumptions in (1) may be derived from the other assumptions in his model;
3. Finally by changing one of those other assumptions I obtain an alternate
result which fits much more closely with what has been observed in the
empirical literature.
Kyle (1989) model is that of a thin market, i.e. with a limited number of traders that
can wield market power. In it, he (and much of the market microstructure literature),

assumes risks to be normally distributed and that traders aversion to risk is independent
of their wealth. Furthermore, he assumes that traders investment demands are inversely
proportional to security prices and that they are all equally price sensitive. I first show
that these last two assumptions are logically equivalent, and then can be derived from
the first two. This is true provided I exclude aberrations such as demand curves with
kinks, discontinuities or singularities. That is a problem Kyle (1989) left unresolved,
though he correctly intuits to be the case. I close this gap when all traders are equally
informed, and when some are more informed than others.
Then I tackle the fact that the assumption of linear proportionality is not supported
by the empirical literature. What the empirical literature has recorded, by various
means, is that demand curves, rather than being linear, are convex. I present a setting
that yields exactly this result, and can be used to fundament empirical estimation. This
result solves yet another problem. An upshot of Kyles model is that in a thin market, in
which liquidity is compromised by gaming market power, traders are price sensitive, i.e.
they do not take them as given. However, as their price sensitivity is constant across
prices, the equilibrium price ends up being the same as if they were in a perfectly
competitive market. Hence, illiquidity has no such impact in this setting. However,
when price sensitivity is not constant across prices (i.e. demand curves are nonlinear),
equilibrium prices vary from perfectly competitive ones. Again, as in the previous
chapter, traded prices will include a liquidity premium or discount in addition to their
intrinsic value.

1.2 Perfectly Rational Financial Bubbles

A microeconomic foundation for credit cycles has long been an unresolved problem
in the finance and economics literature. I demonstrate that the boom-bust credit cycle is
an equilibrium in a market where credit access is unstable. I show that asset bubbles are
the consequence of credit creation and destruction, simply by the entry and exit of new
borrowers into the market. This has a close parallel to the 2008 subprime crisis in the
US that eventually spread internationally.
I believe that the results hereby obtained are both relevant to theory as well as to
public policy.
My intent in developing this line of research has always been to produce results that
are relevant not only to finance theory, but also to finance practice.

Prudential Regulation

One of the consequences that emerged from the 2008 global financial crisis is the
need for prudential regulation reform. Basel II had already been heavily criticised for
being procyclical well before the crisis. Basel III then introduced liquidity
considerations into capital provisioning so as to counterbalance the procyclicality of
Basel II. What I demonstrate in Chapter 4 indicates that further reform is needed to
account for financial access instability as a cause of the booms and busts of credit
cycles. What it further indicates is that banking, as a service to the public, ought to be
regulated in a similar manner to other utilities, in which service licenses are conditioned

on providing access to people at the fringes of society, even if subsidised by others in

the interest of their own safety.

Monetary Policy

Debates about asset inflation have entered central banking circles ever since the
dotcom bubble. The debates peaked at the 2008 financial crisis. There was, and still is,
much controversy between proponents of quantitative easing and fiscal austerity. At the
core of that discussion is the question of whether asset bubbles indeed exist. While they
are apparent to a lot of people, and are talked about in mainstream media, many
recognised experts have claimed, and still do, that market fluctuations are a reflection of
inherent risks of the economy. The latter understanding is a reflection of the lack of
conceptual tools to interpret observed phenomena. The results obtained in my research
provide those very tools, first in Chapter 2 that the difference in economic and financial
risks may be explained via liquidity considerations and then in Chapter 4 that liquidity
may indeed generate asset bubbles and detrimental credit cycles. These tools will then
provide policymakers the conceptual tools with which to frame policy debates and

Executive Incentives

Another hot topic during the 2008 financial meltdown was that of executive
incentives. Much has been debated on the issue of fairness. While my research makes
no contribution to this question, it does raise the question on whether market based
incentive schemes maximise economic value. Ever since the expansion of securitisation
in the 1980s, executives became increasingly more compensated with either direct share

holdings or stock options for the performance of their companies stock prices. Since
the essential result of my research is that stock prices reflect more than fundamental
firm value, then it stands to reason that executive compensation schemes do not only
maximise their firm value, but also its stock liquidity. Much of that has been
anecdotally observed. Executives seemed to be making decisions that were more
aligned with improving their ability to flip their stock in the market than in creating
actual economic value. This is yet another field in which my research may provide a
framework through which empirical research may be interpreted and oriented.

Automated Market Making

The insights provided by the results of my research around the role of liquidity in
financial markets may be a valuable tool for income generation. In particular, Chapter 3
derived explicit optimal investment demand curves which can be translated into limit
order schedules. These may be used to identify trading opportunities when market
discrepancies imply large enough deviation from reasonable assumptions. In doing so,
one may transfer liquidity across assets, asset classes, time and circumstance. The
results of my research provide a practical framework for pricing liquidity and thus
enable market makers to buy liquidity where and when it is cheap and sell it where and
when it is expensive. While that has always been the role of market makers, my results
add science to their art by way of automated into trading algorithms.

Securities Regulation

As with market making, the framework offered by the results of this research may
improve the ability of securities regulators to identify anomalies in the market,

discerning liquidity dynamics from inside information or fraud. Again, large enough
discrepancies from explicit theoretical results around the shape and dynamics of limit
order demand schedules, may indicate significant departures from model assumptions in
which criminal activity is absent.
I suspect that the research I have produced may be just the beginning of practical
applications and further research that it may enable. In a sense, it provides a paradigm
shift from mainstream views about how financial markets operate as characterised by
the current finance literature. Moreover, it does this with the same traditional tools that
have been developed and honed in the literature, e.g. not resorting to heterodox
arguments. I feel this is important because the tools already in place have provided
paramount understanding thus far. I have just pushed them a little further.

2 Wither Equity Premium Puzzle?

Chapter Summary
The meaning of this chapters title is twofold: I propose a solution to the puzzle, while
also predicting its demise. The puzzle emerges from the attempt to explain the
differences in yield between equities and Treasury bills solely from their differences in
risk, requiring absurdly high levels of risk aversion (Mehra and Prescott (1985)). By
acknowledging that equities and Treasury bills differ not only by their levels of risk, but
also by their liquidity, I show that, when transaction costs differ across assets, funding
constraints create a shadow price for liquidity. Thus, it is the combination of asset and
liability illiquidity that generate illiquidity premiums. Further, I argue that the returns in
equities markets observed in the last 25 years are a reflection of dramatic reductions in
their transaction costs, and are likely to taper off as soon as their liquidity ceases to

2.1 Introduction
Between 1896 and 1994 the yearly simple geometric mean equity premium for the
New York Stock Exchanges (NYSE) value weighted stocks was six percent (Campbell,
Lo, and MacKinlay (1997)) and has been approximately eight percent for the last 50
years (Cochrane (2005)). In their cornerstone paper, Mehra and Prescott (1985) attempt
to account for this premium using simulations of an intertemporal equilibrium growth
model with a representative consumer/investor, abstracting from transaction costs,
security market microstructure, liquidity considerations, and other frictions. They are
able to account for only a negligible proportion of this premium with a maximum of
0.4% explained by risk aversion.1
Mehra and Prescott (1985) and the subsequent literature surveyed by Cochrane
(2005) and Campbell, Lo, and MacKinlay (1997) focus on representative agent
equilibriums with agents identical in all respects, including endowments. These are
models of perfectly competitive market equilibriums with no market frictions, such that
Pareto optimality is achieved, with relative prices determined strictly from aggregate
risk preferences and irrespective of trading activity amongst market participants. Once
market frictions are introduced, risk preferences need to be balanced with illiquidity
costs, and hence relative prices are impacted by relative liquidity across investment
assets. Clearly, this impact can only be observed when investors have an incentive to
trade. For that, investors must differ in at least one respect. In the case here they differ

For a review of the puzzle see Constantinides (2004), Heaton and Lucas (2005) and other papers
presented at the UC Santa Barbara Equity Premium Conference, October, 2005.


in endowments. Essentially, I replace the representative investor with investors with

differing endowments to motivate trading while retaining the assumption of identical
preferences. I show that preserving all the standard assumptions of rationality, utility
maximization, and even abstracting from the effects of information and beliefs a simple
exchange model with quite modest barriers in trade explains the major stylized and
empirical facts about equity, bond market returns, and trading turnover over the last 100
I establish in a variety of settings within an exchange economy that the midpoint
price of an asset is unaffected by impediments in to trade such as a small number of
participants (oligopsony) or quadratic transaction costs. We dont explicitly assume the
possibility of final liquidation costs, but that is without loss of generality, as investor
factor those in expectation, treating them as just another transaction cost, though
incurred in the future. It questions the standard assumption that even if only a single
asset is traded its midpoint must fall by the present value of transaction costs.
Superficially, this suggests that illiquidity and trade impediments can never impact asset
returns. Heumann (2005), in a trading model akin to Kyle (1989) with market impact
costs also finds that illiquidity due to oligopsony is not priced. The trading price is
independent of the number of traders, which is a result I also obtained. He attributes
what he calls a surprising result to the two-sided nature of trading: Buyers demand a
price discount and sellers demand a price premium, and these effects cancel each other
out Kyle (1989, p. 5). This result, however, hinges upon the assumption of free
leverage. I show that in the presence of transaction costs, borrowing constraints generate


a shadow price for liquidity which is not only important but can also dominate the price
of risk.
This apparent cancelling out of what are mutual harms due to illiquidity is puzzling
as both trader welfare and liquidity are clearly improving in the number of participants,
despite the implication of the finding that the number of participants is irrelevant to the
outcome. In Kyle's (1989) model, a smaller number of participants make all parties
worse off since the optimal (first best) level of trading occurs when an infinite number
of participants is possible. This means there is no cancelling out of welfare losses. If
there is a choice between regimes, for the less liquid regime there must be a
compensating fall in the asset price relative to the liquid regime. Grleanu and Pedersen
(2004) obtain a similar puzzling cancelling out for informed and liquidity trades with an
intuitive explanation similar to Heumann (2005).
Indeed, this cancelling out and irrelevance of transaction costs for a variety of taxes,
trade barriers induced by market power, and to market clearing prices is something that
has been under investigation by economists for decades in a variety of guises.1 The
irrelevance of market imperfections for midpoint exchange prices, as well as the
irrelevance or who notionally pays the tax or bears the transactions cost, is a
consequence of the fact that barriers in transacting become a tax wedge. It does not
mean that if the illiquid and identical liquid varieties of the same asset trade in the same
market that the prices and returns will be the same. In fact, it is entirely to the contrary.

For example, Samuelson (1964) showed that if an income tax is applied uniformly to cash earnings and
capital gains and losses then asset prices are unaffected by such a taxation regime. However, his result
does not imply that if one traded asset is taxed and an identical one is not, that asset prices are unaffected.


One purpose of this chapter is to show that the price differential between the two
otherwise identical assets can explain the equity premium puzzle of Mehra and Prescott
(1985) as almost entirely due to illiquidity rather than risk. I then extend the model by
allowing any degree of correlation between the liquid and illiquid asset. For example,
the liquid asset could represent T-Bills, rather than equity identical to the costly to trade
asset. I also investigate the implications of introducing traders with different investment
horizons on portfolio choices and returns.
This chapter initially considers a market with perfectly substitutable assets (for the
sake of simplicity, and without loss of generality) with different liquidity. I prevent the
use of the liquid asset as a perfect hedge for the illiquid asset by imposing short sale
constraints. This is reasonable in these circumstances as there are no other players in the
market from whom investors could borrow stock to be sold short. One could argue that
it would be perfectly possible for a seller to, in addition to selling the asset to the buyer,
borrow it from him, and sell it some more, under a repurchase agreement, i.e. a repo, to
buy it back in period 1. In the presence of a liquidity differential, the demand for this
transaction would drive up the equilibrium repo rate to the point of making the
borrowing uneconomic. Alternatively, investors could trade a derivative contract (e.g.
swap, forward, or future) that replicated the payoff of the risky asset. This contract,
however, would carry a transaction cost in its own right, potentially higher than that of
the underlying asset, as in a no arbitrage equilibrium its price should reflect the costs of
replicating its payoff with the latter.


As noted above and in previous work by other authors (e.g. Heumann (2005),
Constantinides (1986), and Vayanos (1998)), I find little to no impact on mid-point
prices as a result of transaction costs while acknowledging that transaction costs can
widen the spread. The key to the result in this chapter that of a significant liquidity
spread is the recognition that a liquidity spread is generated by differences in liquidity
across assets in the market and not simply by illiquidity alone, while investors
(particularly sellers) are unable to circumvent these differences by short selling the most
liquid asset.
Detemple and Murthy (1997) examine the effect of trading constraints on no
arbitrage pricing. More recently, Basak (2008) derives multiplicity of price equilibriums
under portfolio constraints, although that is only the case with more than one such
constraint. Detemple and Serrat (2003) go one step further in considering an
intertemporal economy, albeit with a narrower class of constraints, namely constraints
on liquidity.
These simple models describe a world in which the single asset for which there is a
motive for trade is subject to barriers in either transaction costs, or to illiquidity due to
oligopsony power, in a symmetric fashion. They do not address the question posed by
Constantinides (1986) in his seminal contribution. His concern lay with the rate of
return when expected utility comparisons are made across equilibriums.1 His focus was
the impact on the equilibrium rate of return of a proportional transaction cost when

We thank Kerry Back for making this point strongly.


investors are guaranteed a minimum utility level fully incorporating all gains from
trade. This is provided by a comparison across equilibriums, or in two parallel
economies, with the ability to trade an otherwise identical completely liquid asset with
no transaction costs. Speculators cannot directly arbitrage across equilibriums except in
expected utility terms, preferences matter, and an asset with the same risk differing in
terms of a tradability factor. He defined the illiquidity (or liquidity) premium as the
increase in the assets mean return, or dividend, which combined with the introduction
of transaction costs leaves unchanged the investors expected utility across the two
equilibriums, one with and the other without transaction costs.
In contrast, here I derive an illiquidity premium by comparing rates of return in the
same economy rather than across iso-util economies. My model can explain the cross
sectional returns on the NYSE over the 30 years to 1992 as a function of stock turnover
(Datar, Naik, and Radcliffe (1998)), and the 20% return on letter stock (Silber
(1991)). It can also help to explain changes in the 600% premium on A relative to B
stock prices in China when the assets are otherwise identical, the very small returns on
A relative to B stock and the relative daily returns Chen and Swan (2008).
In a pioneering contribution Amihud and Mendelson's (1986) model expected
discounted cash flow maximization by risk neutral agents with different investment
horizons and hence different intrinsic portfolio turnover rates. There is an illiquidity
premium arising from the existence of multiple securities with differing spreads,
together with a chain of indifferent investors linking the returns on these securities.
Amihud (2002) provides further cross-sectional and time series evidence that the

excess equity return at least partly represents an illiquidity premium. Brennan and
Subrahmayam (1996) find evidence of a significant effect, due to the variable cost of
trading after controlling for factors such as firm size and market to book ratios.
Extensions in the same vein are provided by Easley, Hvidkjaer, and OHara (2002),
Pastor and Stambaugh (2003), and Easley and OHara (2004).
Constantinides (1986) computes the illiquidity premium using numerical simulations
based on Merton's (1971) and Merton's (1973) intertemporal asset pricing model of a
single agent able to rebalance his portfolio of the risky and riskless asset at a specified
cost, with constant relative risk aversion (CRRA) preferences and an infinite horizon.
Davis and Norman (1990), Aiyagari and Gertler (1991), Bansal and Coleman (1996),
Heaton and Lucas (1992), Heaton and Lucas (1996), and Heaton and Lucas (2005) use
the same setting (the latter also models idiosyncratic labour income shocks). Vayanos
(1998) models turnover as endogenously generated by investors with CARA
preferences based on life cycle considerations.1 Huang (2003) also finds a relatively
small liquidity effect.
Lo, Mamaysky, and Wang (2004) consider fixed rather than proportional transaction
costs, unlike Constantinides (1986) and the others mentioned above. Their economy is
composed of agents maximizing exponential utility, while hedging a nontraded risky
endowment with a traded asset whose dividends it perfectly correlates. Liu (2004)
extends that to multiple assets with different transaction costs, in a continuous time, on

See also Vayanos and Vila (1999).


an infinite horizon CARA setting. Jang et al. (2007) finds that by introducing stochastic
regime switching into Constantinides' (1986) model, trade demand increases, and
transaction costs can have a first order impact.
I present the risky security exchange model in Section 2. Simulations of equity and
bond markets from 1896 to 1994 are in Section 3, while Section 4 concludes. All proofs
are provided in the Appendix.

2.2 The Benchmark Case: Perfect Competition

I introduce our notation via the benchmark case of perfect competition. In this
economy all investors are identical with the same risk preference and they differ only in
their initial endowments. Since efficiency requires equal risk-sharing with respect to the
risky asset, investors will trade to the point at which their terminal period holdings of
the risky asset are identical.
There is a single risky asset and no impediments to trading. A pure exchange
economy with two periods, 0 and 1, is composed of N constant absolute risk aversion
(CARA) investors indexed by i , with the same CARA positive coefficient , each with

x0i consumption units in a savings account remunerated at the positive riskless rate r ,
and the remaining initial wealth w0i invested in y0i units of a risky security, with
aggregate positive supply of Y units. This riskless rate need not be the same as the yield
on a riskless Treasury bond that might benefit from a liquidity premium. The risky

security yields a normally distributed (terminating) dividend payoff of v consumption

units, with mean and variance 2 . Each investor i chooses the amount i of the
risky security to trade from his initial wealth w0i , measured in consumption units, in
period 0 , in order to maximize expected utility over consumption in the terminal
period, period 1 . Consumption in the initial period 0 is irrelevant to the model with the
investor choosing his period 1 consumption equal to his terminal portfolio consisting of
a combination of the riskless and risky asset with all benefits and outlays measured in
consumption units.
Proposition 2.1: Under perfect competition with N price taking CARA investors in
this economy, the market clearing equilibrium price is given by the present value of the
terminating dividend payoff in the second period, period 1, , minus a risk discount
that depends on the mean number of investment units per investor,

, their risk

preference CARA coefficient, , and variance, 2 :


2 Y

1+ r


Each investors post-trade holding of the security in period 1 is denoted by y1i . Investors
share the total stock of the risky security equally amongst themselves in the next
(terminating) period so as to perfectly share the risk in a Pareto efficient manner. As
there are no barriers to trade, each one holds the same quantity, y1i , in equliibrium:

y1i =

, i ,


with a purely competitive trade size (denoted by subscript C ), along with no

impediments to trade such that post-trade holdings are equalized:

Ci =

y0i , i ,


and consumption in period 1 is given by:

cCi =

ln (1 + r )
+ (1 + r ) ( x0i Ci p ) + ( y0i + Ci ) 2 ( y0i + Ci ) , i .
(2 + r )


This expression (2.4) for the value of consumption of the ith investor in the second
(terminal) period, period 1, consists of the valuation of the ith investors two assets, his
liquid money holdings, x0i Ci p , and his risky asset holdings, y0i + Ci , after his trades
have occurred. These components make up his after-trade portfolio in the terminal
period. Its primary determinants are the terminating mean dividend (i.e., valuation in
consumption units) per unit of the risky asset and each investors identical terminal
period holdings of the risky asset, y1i = y1 =

= y0i + Ci , as perfect risk-sharing is

accomplished in the absence of trade barriers. The final term in the expression,
1 2 i
( y0 + Ci ) , reflects risk-bearing costs that have been minimized across this

economy of otherwise identical investors, differing only in initial endowments.

2.3 Quadratic Transaction Costs

Proposition 2.2: With quadratic costs denoted by Tran that are defined in numeraire
units of consumption, with

Tran =

k ( ) ,


where denotes the trade size and the quadratic transaction cost coefficient k > 0 , the
midpoint price is the same as under perfect competition (equation (2.1) above). Trade
size is given by:


y0 ,
+ (1 + r ) k N


and thus is diminishing in the quadratic transaction costs parameter, k.

2.4 Imperfect Competition (Oligopsony)

In the previous Sections 2.1 to 2.3 models investors are nave in the sense that they
take prices as given and do not take into account the adverse market impact that their
own actions will have upon them. In order to incorporate strategic behaviour, which in
turn justifies our quadratic cost approach, we assume that investors conjecture each
others demand functions to be linearly decreasing in price:

h = h h p, h i .


Proposition 2.3: The Nash equilibrium market clearing price, in a two-period

economy of N CARA investors under oligopsony, is the same as in the perfectly
competitive case (2.1), p =

2 Y

, but allocations depend on the purely
1+ r

competitive Pareto efficient allocation

, on the initial endowments y0i , and on the

number of strategic investors:


N 2 Y
y =
N 1 N N 1


with the optimal strategic trade size:

ICi =

N 2 Y
y0 ,
N 1 N


where IC
denotes the optimal trade size under Imperfect Competition (oligopsony).

This is so because where investors have market power due to a limited number of
market participants, market impact costs act as a barrier to trade precisely like a form of
(quadratic) transaction costs. Barriers to trade are a form of transaction cost (tax
wedge) that does not distort the midpoint price but buyer and seller prices differ by the
spread induced by the transaction cost wedge. In the Appendix for this chapter, we
establish that this strategic effect of market power is equivalent to the quadratic
specification for transaction costs given above in equation (2.4). Moreover, quadratic
transaction costs are the only form consistent with equilibrium when agents differ in
size or market power.

2.5 Illiquid Security with a Liquid Substitute

Consider a one-period market of two types of CARA investors, buyer and seller,
denoted by superscripts B and S respectively. Both buyer and seller hold cash on a
savings account remunerated by a riskless rate r, but with only the seller holding a risky
asset endowment. We assume this for the sake of simplicity of notation, and without
loss of generality, as the absence of wealth effects from CARA preferences leaves any

equity held in common immaterial to trade. There are two types of risky assets, liquid
and illiquid, denoted respectively by subscripts L and I, traded at the expense of a
quadratic transaction cost, Tran , with coefficients k L and k I (with k L < k I ),
respectively, where ( ) denotes the square of the trade size1:

Tran = k L ( L ) + k I ( I )


I provide motivation for quadratic transaction costs in the Appendix. It stems from
strategic, rather than price taking, nature of trading. Each asset has liquidation values vI
and vL , respectively, that are normally distributed with respective means I and L ,
variances I2 and L2 , and covariance I L .
Neither of the assets can be short sold. One could argue that it would be perfectly
possible for a seller to, in addition to selling the asset to the buyer, borrow it from him,
and sell it some more, under a repurchase agreement, i.e. a repo, to buy it back in period
1. In the presence of a liquidity differential, the demand for this transaction would drive
up the equilibrium repo rate to the point of making the borrowing uneconomic. Thus
assuming a hard constraint is without loss of generality. Moreover, there is no derivative
contract available to mimic the assets payoff at the lower cost. As we will see below,
sellers will use the liquid asset as a partial substitute to the illiquid one to reduce their
risk. Thus if the supply of the liquid asset is smaller than that of the illiquid one, sellers

As we specify the mean payoffs to the liquid and illiquid asset, as well as their marginal transaction
costs, our definition of the relative supply of the two securities is immune to simple stock-split


will not be able to completely reduce their risky holdings, and the short selling
constraint will be binding. Later, we look into varying the proportions of liquid and
illiquid assets in the market.
If liquid and illiquid assets are partial substitutes and the supply of the liquid asset
sufficiently smaller than that of the illiquid one in relation to how much risk investors
wish to share, then they will trade as much as they can of the liquid asset first, and then
trade the remainder risk through the illiquid one.
We denote the buyer by superscript B and the seller by superscript S , and their
wealth, riskless and risky holdings by w, x and y, respectively, denoting liquid and
illiquid securities by L and I, respectively:

wS = x S + yIS pI + yLS pL , and

wB = x B + yIB pI + yLB pL .


We also denote buyer and sellers post-trade holdings of securities and cash,
respectively, by y and x :
y IS = YI I ,

y IB = I ,

yLS = YL L ,

y LB = L ,

YI > YL ,


x S = x S c S + IS pL k I ( IS ) k L ( LS ) , and
x B = x B c B + IB pL k I ( IB ) k L ( LB )



Given the smaller aggregate supply of the liquid asset, its short sale constraint will be
binding (as argued above), i.e. L = YL . Hence, buyer and sellers final wealth are:

wS = (1 + r ) x S + y IS vI + yLS vL , and


wB = (1 + r ) x B + y IB vI + yLBvL .

The seller and the buyer then choose their respective consumption levels and trading
volume to maximize their expected exponential utility of terminal wealth:

( )}
{ exp( c) E exp( w )},

S !S !S
arg max
exp ( c ) E exp wS , and
c , I , L =


( I L) ( I L) ( I L)
B !B !B
arg max
c , I , L =
( c, I , L ) s.t. ( I , L ) < (YI ,YL
where E [


] denotes the expectation and

denotes the constant absolute risk aversion

(CARA) coefficient common to both buyer and seller.

This optimization yields two first order conditions with respect to the final period
consumption of the seller and buyer, respectively:


ln (1+ r )


rc S + (1+ r ) x + pI ! I + pLYL 12 k I ! I 12 k L ! L


+ I YI ! I 12 I2 YI ! I , and


ln (1+ r )


!B 1 !B
rc + (1+ r ) x pI I pLYL 2 k I I 2 k L L

+ I ! I + L! L 12 I2 ! I I L! I YL 12 L2YL 2 ,



with the remaining four of the six (in total) conditions specifying the optimal trade-size
conditions for the seller of the illiquid and liquid assets, respectively, and the buyer of
the illiquid and liquid assets, respectively:

0 = (1+ r ) pI k I ! I I + I2 YI ! I ,

0 < = (1+ r ) ( pL k LYL ) L + I L YI ! I ,

0 = (1+ r ) pI + k I ! I + I I2! I I LYL , and


0 = (1+ r ) ( pL + k LYL ) + L I L ! I L2YL ,


where is the shadow price of the sellers short selling constraint, and superscript $
indicates that the condition is evaluated at the optimum trade size value. Market clearing
requires that purchases and sales net to zero. Hence:

! I ! I ! I =

+ (1+ r ) k I


This result is different from the frictionless result, in which both investors equally
share the aggregate supply of risky assets. In this case, we regard the stock of the liquid
asset YL transferred from seller to buyer as being outside of the risk sharing problem,
due to the lack of wealth effects generated by the investors CARA preferences.


Liquid stock
Iliquid stock

Figure 2.1 The seller transfers to the buyer his liquid stock (light
grey), and then some illiquid stock (dark grey).
One can easily verify that the trade volume above converges to the frictionless

market case, I = I
when k I 0 , and that the market converges to autarky, i.e.

I = 0 when k I .
By substituting the market clearing trading volume into the first order conditions
(2.13) we can solve for the equilibrium prices:

pI =

, and
1+ r

pL =
L2YL k LYL .
L I L 2
1+ r
I + (1 + r ) k I


Given the analysis above, it is no surprise that the transaction cost does not change
the price of the illiquid asset, while only commanding a liquidity premium over the
price of the liquid asset.






Illiquid Asset
Liquid Asset







Illiquid Asset
Liquid Asset











Transaction Cost (k)






Figure 2.2 Equilibrium prices for liquid and illiquid assets with varying
transaction costs and volatility

( r = 2%; I

pI = 10.0%; L pL = 2.0%; = 0.155; kI = 0.0015; kL = 0.0;

I pI = 18.78%; L pL = 1.02%; = 1.29%)

Carrying out comparative static analysis of increases on the two transaction cost
regimes for the price of the relatively liquid asset yields:

> 0, and L = YL < 0 .
k I
k L


Hence, the more expensive it is to transact the illiquid asset, the higher the price of the
liquid asset. Moreover, as the cost of transacting the liquid asset rises, the lower is both
its price and its price premium. The greater the supply of the liquid asset, YL , the
greater its price reduction for a given rise in transaction cost.
Finally, consumption levels can also be determined in equilibrium:


c S = 1+ r 1 x S + ( pI 12 k I )! I + ( pL 12 k L ) YL

ln (1+ r )

c = 1+ r


ln (1+ r )

+ I YI ! I 12 I2 YI ! I

x ( pI + k I )! I ( pL + 12 k L ) YL + I ! I + LYL


12 I2! I I L ! I YL 12 L2YL2 .


We now compute the particular case in which liquid and illiquid assets are identical
except for differing liquidity (one illiquid and one perfectly liquid), as we will then be
able to derive some economic intuition from it. For this case, we impose the following
restrictions on the model above:

= I = L ,
= I = L,
= 1,


k L = 0.
By using these parameter specifications in equation (2.14), we find the volume
traded in the illiquid asset:
! I ! I ! I =

+ (1+ r ) k I 2


We note that in this case, it is clear that, once the liquid asset changes hands, both
buyer and seller are only interested in risk sharing over the supply of the illiquid asset
net of the liquid asset supply already in the hands of the buyer. Also, by using equation
(2.15) we compute the equilibrium prices:

pI =

2 YI + YL

1+ r

pL =


1+ r
2 + (1 + r ) k I 2


The liquidity premium, , is defined as the extent to which the price of the liquid asset
exceeds the illiquid asset price, and can be expressed as:
= pL pI = k I ! ,



where k I is the marginal cost of trading the illiquid asset.

This particular case clearly illustrates the effect of a difference in liquidity, when that is
the only difference between two identical assets. In this case, the liquidity premium is
simply the transaction cost at the margin of the equilibrium trading volume. This is the
price differential both investors are willing to accept, as both know that, once they trade
on the liquid asset, this is the incremental transaction cost they will incur for an
additional unit of the illiquid asset. Moreover, it precisely reflects the simple intuitive
form that the binding short-selling constraint takes in this special case.

2.6 Model Calibrations


Calibrating the Two Risky Assets Model

The model assumes that there are two risky assets, a (relatively) illiquid asset that we
take to correspond to equity traded on the NYSE and a corresponding counterpart which
we take as United States (US) Treasury bonds. So long as there is a market friction in
the equity market, liquid Treasury bonds provide the primary means of risk-sharing,
inducing a premium in the price and thus a decline in the yield on Treasury bonds.
Hence, the yield on Treasury bonds is below that of the riskless rate that savers receive
due to the formers liquidity premium. The higher is the transaction cost on equity
relative to Treasury bonds, the lower is the yield on Treasuries and thus the higher is the
equity premium which is measured as the difference between the yield on equities and
the yield on Treasuries. Outside the realm of model building, we tend to think of the

yield on equity rising as the equity premium increases, rather than the yield on Treasury
bonds falling below the riskless return on savings, but all that matters is the relative
yield, or relative prices of Treasury bonds and equity, explained by the model.
As is well known in the standard Mehra and Prescott (1985) risk-based approach to
the equity premium puzzle, when the model is calibrated to explain the equity premium,
a new puzzle is posed: why is the Treasury bond yield so low? This is Weils (1989)
risk-free rate puzzle. This new puzzle does not arise with the illiquidity approach
developed here as the equity premium is not due to risk and aversion to intertemporal
substitution to begin with.
Needless to say, when bond rates rise (i.e. price of Treasury bonds fall), so do stock
prices, and vice-versa. Thus, stocks and bonds are substitutes, although imperfect ones.
Treasury bonds trade at low bid-ask spreads of 1 to 3 basis points; thus, are far more
liquid than is equity. Over the 17 year period of 1996-2012, the average turnover rate on
marketable Treasury bonds was 31.66 times per annum, while on the NYSE the
comparable rate for equity was 1.23 (Table 2.1 and Figure 2.3). The ratio of the security
turnover rate to the equity turnover rate was, on average, 25.80 times over this period.


Table 2.1 Yearly Turnover Rates for US Treasury Securities and NYSE Equities,
Daily Volume
Year Treasuries
Mean Turnover Rate

Yearly Turnover
NYSE Treasuries

Figure 2.3 Yearly Turnover Rates for US Treasury Securities and NYSE
Equities, 1996-2012

The much greater liquidity of Treasury bonds is not an exclusive property of the US
market. Data is also available for Australia and the UK. In 1992, the annual turnover of
Gilts (all UK Government Bonds) by final customers was 3.6636 times. For the equity
of UK and Irish companies, it was 0.4308 on the London Stock Exchange (LSE). If the
intra-market turnover of both Gilts and equity is included, the rate for Gilts rises to
7.125 times annually and 0.6948 for equity (London Stock Exchange, 1992).1 Gilts are
reasonably liquid with the entire stock turning over every 1.68 months, but less so than
the US. Since professional market makers may not be as sensitive to transaction costs, it
is better to focus on final customer trades.
The turnover rates for Australian Commonwealth Government bonds were 8.33 in
1993-94, 11.58 in 1994-95, 9.22 in 1995-96, 10.77 in 1996-97, and 8.61 in 1997-98
(Briers et al. (1998)). Hence, these bonds have higher liquidity than Gilts. Over the
same five-year period, equity turnover on the ASX rose from about 0.25 to 0.5 times per
annum, so that the ratio of bond to equity turnover fell from 33.3 to 17.2 times over this
period.2 The average experience over this period is quite similar to the US.
Consequently, government bonds (including Gilts) are exceedingly more liquid, i.e.
with higher turnover, than equity in all three countries. Thus, if we were to explain the
demand for trading Treasury securities by investors with identical preferences to those

In 1992 the total value of trades in Gilts was 1,238,791 billion British Pounds with an estimated
valuation of 173,865.3 billion Pounds. This estimate was computed from data supplied by the London
Business School. The total value of trades in equities was 433,858.9 billion Pounds for British and Irish
companies traded on the LSE with an estimated value outstanding of 624,393.3 billion Pounds for British
and Irish companies.
This relative change is largely due to the halving of stamp duty on stock exchange transaction from July


trading equity, we would expect to find significant differences in transaction costs

between the two markets, with a much lower or negligible illiquidity premium for liquid
I attempt to explain what I believe to be the important features of both equity and
bond markets over nearly a 100-year period, such that all investors have identical meanvariance (exponential) utility functions with identical CARA coefficients. A simple
numerical example based on simulating the quadratic transaction cost model of Section
2.5 above is provided in Table 2. It is designed to help understand of the model and to
replicate important features known about the performance of US stock and Treasury
Bill markets from 1889 to 1978, which was the subject of Mehra and Prescott's (1985)
equity premium study. The key facts are a mean 6.921 percent per annum equity
premium over the yield on short term government securities, an 18 percent annual
standard deviation of returns (3.24 percent2 variance), and a 2 percent per annum real
return on Treasury bonds ((Campbell, Lo, and MacKinlay (1997)). Cochrane (2005)
reports an equity premium of eight percent over the last 50 years in the US. Jones
(2002) computes the average round trip relative transaction cost (spread plus
commission relative to price) of approximately 1.68 percent over 1925-2000 for the
largest and presumably most liquid Dow Jones stocks on the NYSE. Costs over 18891924 are likely to have been similar or higher. The annual average stock turnover rate is

While Campbell, Lo, and MacKinlay (1997) suggest 6 percent, it is often quoted as 6 to 8%. Hence, we
have simulated a higher number, 6.9%, here.


conservatively 40 percent per annum. Joness estimated annual average round trip
resource cost is approximately 0.76 percent per annum.
To be on the conservative side, and to represent more recent experience following
deregulation of commission rates in the 1970s, a conservative single trip relative rate of
0.0034, or just 0.34 percent, is assumed. To achieve this rate, a quadratic transaction
cost coefficient k1 is set at 0.054. Luttmer (1996) computes the two-way bid-ask spread
for 3-month T-bills to be far lower than for equity at only 0.03 percent, although higher
on an annualized basis. For simplicity, and without loss of generality, we use zero
percent here for the liquid asset, and hence k L = 0. The higher the coefficient of absolute
risk aversion (CARA) , the higher is the propensity to trade. is set to 1.6 so as
produce a reasonably representative, annualized turnover rate for the illiquid asset
(equity) of 39%. This CARA coefficient corresponds to a Constant Relative Risk
Aversion (CRRA) coefficient of 3.976 for the seller.1 The endowment of each buyerseller pair is YIB = 0, YIS = 2.6;YLB = 0;YLS = 0.2 , x0B = 3.8, x0S = 1.2 so that the entire stock
of the risky asset is in the sellers hands with shares in the illiquid variant (YI )
outnumbering the scarcer liquid variant (YL ) .

In the CRRA model utility of wealth (consumption) u ( w) =

, where is the coefficient of CRRA,

and in CARA specification, u ( w) = e w . Equating marginal utilities and solving for the CRRA
coefficient yields = (ln w)

( w + ln ) .

Evaluating for the expected buyer wealth level in the

simulation yields the figure quoted in the text.


In the standard Capital Asset Pricing Model (CAPM), the length of the single period
is arbitrary and is essentially undefined. In my model, we are required to explain both
the trading and turnover of equity and its liquid counterpart. This means that the
decision period cannot exceed the horizon period of an investor in such a liquid security
or, implicitly, an investor is able to trade assets free of all transaction impediments in a
perfect market. Table 2.1 shows recent evidence that, on average, Treasury bonds turn
over in the US approximately every one and one half weeks, rising to three weeks (17
times pa) by 2012. The investment horizon is set at 3.25 weeks (T = 0.063) to
replicate the average turnover rate for Treasuries of 16 times per annum applicable to
the 25 year period ending in 2004. Hence, we assume approximately three-week
portfolio rebalancing for both equity investors, so that all reported values generated by
the model, such as the expected returns and illiquidity premium, are annualized values
generated from the model. We adjust the volatility of the risky asset with respect to the
period length to make the standard, annualized CAPM risk premium independent of the
investor horizon. The draw of the annual yield on the risky asset ( 1) is set at 5% per
annum, yielding a return over the horizon period of 0.31% and the equivalent annual
return on the riskless money asset x is r =2% or 0.12% per period.


Table 2.2 Model calibration example liquid and illiquid assets, parameters, and results
Illiquid Asset
Variable Value
I 1.60

Expected liquidation value

I pI

Transaction cost coefficient

Value volatility
Return volatility
Aggregate supply
Traded volume
Turnover rate
Relative marginal transaction cost
per unit traded
Average marginal transaction cost
per unit traded



( I


I pI




pI 0.91%

pI )

L 0.0000
L 1.60%
L pL 1.02%


I pI

Dividend yield of the illiquid asset

Liquid Asset
Variable Value
L 1.60


pL 1.5685
L pL 2.0%


1 9.95%


( L

pL )


1 2.01%

Table 2.3 Model calibration example general parameters and results

Investment horizon
Riskless rate
Money supply initially in the sellers hands



Money supply initially in the buyers hands

x0B 3.80
CARA coefficient
Equivalent CRRA coefficient
Partial correlation coefficient
Liquidity spread
= pL pI 0.1134
Equity premium (annualised return on illiquid asset)
Risk premium
Liquidity premium

We now show that this stylized model is capable of replicating return premiums of
traded stock as famously noted by Mehra and Prescott (1985). We obtain an annualized

liquidity premium of 5.41% that covers almost the entire 6.18% equity premium that
would be required in equilibrium. In this example, the illiquid asset supply is 130 times
greater than the liquid asset, which is not too far off from what we observe comparing
the equity, corporate debt, and emerging markets to the money markets. A striking
feature of this simulation is that the real return on the liquid asset is negative. This is not
so unintuitive, once we take account of the convenience yield of money as a liquid
means of exchange. Raising the period length from 1/16th of a year to of a year raises
the return on the liquid, money-like, risky asset from -53% p.a. to approximately 1%
p.a. This is closer to the observed return on liquid assets such as T-bills. This very
substantial increase in the length of the horizon has negligible impact on either
illiquidity or risk premiums.

Explaining the Cross-Sectional NYSE Returns, 1962-1991

Datar, Naik, and Radcliffe (1998) observe that a one percent drop in the monthly
percentage stock turnover rate for nonfinancial firms on the NYSE increases the crosssectional monthly return by 4.5 basis points over 1962-1991, conditional on the Fama
and French (1992) factors, size, book to market, and CAPM beta. Examining the impact
of a 1% fall in the transaction cost rate k I in the model set out in Table 2.2 and Table
2.3, the illiquid stock turnover rate rises by 1%, and the monthly illiquidity premium
falls by 15 basis points. This simulated impact is greater than in Datar, Naik, and
Radcliffe (1998), but this may be so because their estimate is highly conservative. Since
larger stocks have lower transaction costs, the estimate of 4.5 basis points understates
the full liquidity effect.


A Test of the Model based on Letter Stock Returns

Silber (1991) estimates the magnitude of the illiquidity premium by estimating the
discount on letter stock. Letter stock is a form of private placement that is issued by
firms under SEC Rule 144. It is identical to regular stock, except that it cannot be traded
for a period of typically two years1. Pratt (1989) summarizes the results of eight
separate studies of the discount ranging from 17.5 to 20% per annum. Simply raising
the transaction cost coefficient k1 by a factor of 3.7 in the simulation depicted in Table
2.2 is enough to raise the illiquidity premium to 20% per annum as an approximation to
the impact of enforced autarky (absence of trading).

Are the Findings Really Plausible?

In this section we consider some objections that have been raised to the finding that
even a small transaction cost fully explains the equity premium puzzle.
In the illiquidity/loss of gains from trade approach, no relationship is needed between
returns volatility and volatility in the growth rate in consumption. The driving force is
trading volume induced by trading impediments, no matter how motivated, and not risk.
Moreover, the illiquidity explanation for the equity premium and the low, or even
negative, return on the liquid asset relaxes the representative investor model on which
these tests rely. Hence, there is no need for an explanation for the low consumption
volatility, nor for the variance bounds tests of Hansen and Jagannathan (1991).

In Australia there is a similar concept relating to shares owned by the founders at the time of an IPO.
There is typically an escrow period of two years.


It is an implication of the model that the equity premium is a consequence of two or

more assets trading in combination with differing trading frictions and an inability to
overcome these costs via short selling the more liquid asset. In spite of declining costs
of trading, Hagstrmer, Hansson, and Nilsson (2013) found no downward trend of the
illiquidity premium from 1927 to 2010. My model explains this apparent paradox by
noting that, while trading costs have fallen for both stocks and bonds, relative illiquidity
has remained fairly constant.
The relative trading data for bonds and equity over the last 25 years presented in
Table 2.1 above indicate that bond and equity turnover have both grown in response to
falling costs. The premium depends mostly on differences in the degree of friction in the
two markets.
It might seem that the endowment heterogeneity and portfolio shock frequency
required to calibrate the model, explaining the returns and trading history of equity and
bonds over the last 100 years, is relatively high (Table 2.2). However, we could
interpret endowment heterogeneity as no more than an illustrative transparent device to
generate observed trading demands under identical preferences, identical beliefs,
absence of asymmetric information, absence of trades for purely consumption purposes
(liquidity trades), absence of intergenerational trading, and so on. While relaxing any of
these assumptions may place less reliance on endowment heterogeneity, I have shown
that none of these requirements, including CARA utility which dispenses with income
or wealth effects, is actually required to explain observed equity premiums and trading

2.7 Conclusions
I have shown a stylized model that can generate liquidity premiums, once the
inability of investors to short sell the risky asset is taken into account. Previous models
of financial market equilibrium with transaction costs failed to generate effects on
prices from illiquidity, largely by ignoring the required market microstructure for taking
short positions (i.e. availability of assets to be borrowed at no cost, or of similarly
frictionless derivative contracts). By taking this trading constraint into consideration, I
was able to show that liquidity premiums may exist not as a result of illiquidity per se,
but as a consequence of liquidity differentials amongst similar assets that cannot always
be used as perfect hedges of one another. One such application of the model is its
calibration to fixed income and equity markets, so that the equity premium may be
explained not only as a result in risk differentials, but also of liquidity differentials.


Proof of Proposition 2.1: Investors maximize expected utility over final (terminal)
wealth w1i , as measured in consumption units, by choosing the optimal competitive trade
size Ci :

Ci = arg max E exp ( w1i )

= arg max (1 + r ) x1i + y1i 12 2 2 ( y1i )

= arg max (1 + r ) ( x0i Ci p ) + ( y0i + Ci ) 2 ( y0i + Ci )

(1 + r ) p
y0i .


Investors trade with one another and the market clears with total supply Y of stocks:

0 = Ci = N
i =1

(1 + r ) p
Y .


Hence, the price equation (2.1) in Proposition 2.1 is obtained:


2 Y

1+ r

From equation (2.22), equation (2.3) is obtained:

Ci =

y0i , i .


y1i =

, i !



Proof of Proposition 2.21: Aggregating linear demand schedules, and netting trades to

0 = ICi + h p h ,
h i


h i

where h and h represents the intercept and slope, respectively, of the linear
investment demand function for investor h , with IC
denoting the optimal trade size

under Imperfect Competition (oligopsony).

Hence, the upward sloping supply function facing trader i:

p = p i + i ICi ,


with slope:

= h ,
h i


and intercept on the price axis:

pi = i h .


h i

Investors maximize expected utility over consumption:

ICi = arg max (1 + r ) ( x0i p ) + ( y0i + ) 12 2 ( y0i + )

= arg max (1 + r ) ( x0i p i i 2 ) + ( y0i + ) 12 2 ( y0i + ) ,

The exposition of this proof is based to some extent on Heumann (2005) and improves on the approach
used in an earlier version of this chapter while preserving our conclusion that in the absence of investor
choice between the illiquid asset and an otherwise identical alternative that the market clearing price is
unaffected by the trade impediment.


Then, by first order conditions,

0 = (1 + r ) ( pi + 2 iIC
) + 2 ( y0i + ICi ) ,

and from (2.26),

0 = (1 + r ) ( p + iIC
) + 2 ( y0i + ICi ).

Hence, investor demand schedules are indeed linearly decreasing in price, and
consistent with their initial conjecture:

ICi =

2 y0i

+ (1 + r )

1+ r
+ (1 + r ) i




2 y0i

2 + (1 + r ) i

1+ r
= 2
+ (1 + r ) i

i {1,..., N }


Solving for the demand price sensitivities yields the equally price sensitive
coefficients with the degree of illiquidity the same for all investors:

i =

( N 2 )(1 + r )

( N 1)



i =

N 2 1+ r
N 1 2



Since enters in precisely the same linear form, i , in the oligopsony problem as
in the quadratic optimisation of Proposition 2.2 above, the shadow price is equivalent
to the quadratic cost parameter k defined in equation (2.4) above.
Investor demand intercept differ only by their initial endowments:

N 2
2 y0 .
N 1


N 2 (1 + r ) p

N 1


i =
From equation (2.26),

i =

On netting trades to zero:


N 2 (1 + r ) p

N 1


Hence, given the stated conditions, the market clearing price under imperfect
competition (oligopsony) is the same as in the perfectly competitive case, equation (2.1)


2 Y

1+ r


Substituting the price p above into equation (2.6), yields the strategically optimal
trade, equation (2.8) in the text:

ICi =

N 2 Y
y0 .
N 1 N



Hence, the period 1 risky asset demand is

y1i = y0i + i =

N 2 Y
+ 0 ,
N 1 N N 1


given by equation (2.5) in the text above. !

3 Linearity and Nonlinearity of Limit Orders in Thin


Chapter Summary
I show that one obtains a unique nonlinear equilibrium solution to Kyle's (1989) model
when risk neutrality is substituted for CARA preferences, reconciling market
microstructure theory with the empirical literature. Boulatov and Kyle (2012) and
McLennan, Monteiro, and Tourky (2014) show that the linear equilibrium is unique
amongst smooth solutions in Kyle's (1985) model, hitherto an open problem. This
makes it difficult to reconcile it with the empirical market microstructure literature,
which shows limit orders to be nonlinear on prices or, similarly, price impact to be
nonlinear on volume. I thus turn to Kyle (1989) as an alternative specification to
reconcile theory with observation. I show that the linear equilibrium is the unique
smooth solution to Kyle (1989) under its risk preferences and distributional
assumptions, until now also an open problem. However, in contrast with Kyle (1985), I
show that by replacing CARA with risk neutrality I obtain a nonlinear equilibrium,
which can be used to estimate illiquidity in a market from observed nonlinearities.


3.1 Introduction
Much of the market microstructure literature initiated by Kyle (1985) focuses on
resolving the equilibrium flow of liquidity and information in financial markets. The
key concern is how informed traders trade to benefit from privileged information
without leaking it to uninformed market makers. Market makers, in spite of the
information asymmetry, set the price for liquidity through the bid-ask spread for various
trade quantities in the limit order book. The vast theoretical literature generally assumes
the equilibrium bid-ask spread, or equivalently the slippage cost of trade execution, to
be a linear function of volume, following Kyle (1985). As Rochet and Vila (1994) point
out, the linearity assumption is purely ad hoc. Multiple nonlinear equilibriums may
exist, as in the perfect Bayesian signalling equilibriums of Laffont and Maskin (1989,
1990) and others. In fact, in a generalization of Kyle (1985), Bhattacharya and Spiegel
(1991) point to the possibility of multiple nonlinear equilibriums in a model with a
single risk averse informed trader and a continuum of competitive risk averse
(uninformed) traders, all with normally distributed returns and CARA preferences.
McLennan, Monteiro, and Tourky (2014), on the other hand, resolve the uniqueness
problem left open by Kyle (1985) in its exact specification. Rochet and Vila (1994) had
noted that, in the absence of uniqueness, it is impossible to address two important
questions: (i) what are the welfare properties of a rational trading equilibrium with
imperfect competition in the provision of information and (ii) how much information do
prices and trading reveal in the noncompetitive equilibrium?
The empirical literature on the price impact of trade volume is not supportive of the
linearity assumption (Kraus and Stoll (1972), Hasbrouck (1991), Berger et al. (2008)).
As I demonstrate in this chapter, in Kyle (1989), linearity of bid and ask curves is


equivalent to symmetry across all participants. That is, informed traders are equally
price sensitive, and liquidity providers are equally volume sensitive. This seems
counterintuitive. We would expect a large trader to be less price sensitive than a small
trader, and a small market maker to be more volume sensitive than a large one. Here, I
do not rigorously define small and large, but that may be taken to be a representation
of the participants market power through their endowment or access to funding.
This chapter is divided into four main sections, a nontechnical appendix and a
technical one. The nontechnical appendix is subdivided into three subsections. This is
Section 1. Section 2 reviews the literature in greater detail. Section 3 presents the main
result and Section 4 concludes. The nontechnical appendix demonstrates uniqueness of
Kyle's (1989) conjecture, with and without asymmetric information, within the realm of
smooth demand schedules. All proofs are in the Technical Appendix.

3.2 Literature
Bhattacharya and Spiegel (1991) point to the possibility of multiple nonlinear
equilibriums in a model with precisely the CARA and normally distributed returns
assumed in our proof of the uniqueness of the linear solution. They show that their set
of equilibriums with a continuum of liquidity providers collapses to a unique linear
equilibrium when the arbitrary complex constant in their solution is zero (their
Proposition 9).
Rochet and Vila (1994) point out that linear equilibriums are generally ad hoc by
confirming Kyle's (1985, 1989) results are restricted to the class of linear equilibriums.
They then raise the question of whether they hold independently of linearity for a highly
special case, in which all agents are risk neutral. They show equivalence between a


reconstituted Kyle's (1985) model and a limiting version of Kyle's (1989) model with a
continuum of risk neutral uninformed market makers and a single risk neutral informed
trader. In the original model, there are finite numbers of both risk averse informed and
uninformed speculators. In their version of the Kyle's (1985) model, the insider not only
sees his own trades, as in the original model, but also sees the amount of noise trading
such that the insider effectively places limit orders. This is quite different from the
original model in which only the market maker sees the aggregate order flow. Under
these extreme conditions they establish an invisible hand property specifying a unique
equilibrium that justifies linearity for normally distributed returns.
Bagnoli, Viswanathan, and Holden (2001) examine necessary and sufficient
conditions for linearity for a range of distributions, generalizing Kyles results, as well
as similar models of strategic trading. They conclude that many of the comparative
statics regarding price sensitivity, number of strategic traders, and variability of
exogenous trading derive from the linearity of the equilibrium and not from any
primitive distributional assumptions. Their results, however, do not rule out nonlinear
equilibriums, as traders and market makers conjecture one anothers strategies to be
linear by assumption.
Foster and Viswanathan (1993) show that a linear equilibrium exists for any number
of strategic traders if the joint distribution of the exogenous risk factors is elliptical,
even when they are not independent. Nldeke and Trger (2006) show the reverse; if a
linear equilibrium exists, then the joint distribution of the exogenous risk factors is
elliptical. Bertsimas and Lo (1998) and He and Mamaysky (2005) solve for the optimal
trading strategy that minimizes the execution costs under linear price impact. Vayanos
(1999) extends Kyles analysis to a continuous time dynamic setting, though he also
keeps the assumption on linearity. Pereira and Zhang (2010) assume price impact

returns to be proportional to traded volume and show that liquidity premiums are
concave on price impact and volume. Huberman and Stanzl (2004) find that a restriction
on price manipulation rules out nonlinear permanent price impact. They focus, however,
on sequential equilibria in which traders are only able to submit market orders,
differently from the setting in this chapter and from others in the microstructure
literature exploring Kyle's (1989) model.
Vath, Mnif, and Pham (2007) solve Mertons investment consumption problem in
continuous time under liquidity risk and price impact whose log return is also
proportional to traded volume. Obizhaeva and Wang (2005) calculate the cost savings
obtained from adopting an optimal execution strategy in a dynamic context under linear
price impact. Almgren (2003) generalizes the optimal execution problem to power law
price impact functions, but does not determine them in equilibrium. Weretka (2011)
builds a static model of endogenous market power in which he finds price impact
functions to be linear in equilibrium. He makes the simplifying assumption, however,
that traders care only about the linear approximation to the markets investment demand
at the equilibrium.
On the empirical front, Kraus and Stoll (1972), Hasbrouck (1991), and Keim and
Madhavan (1996) provide evidence that the price impact function for upstairs block
trades at the NYSE is concave rather than linear. Spiegel and Subrahmanyam (2000)
also find equilibrium prices to be concave for large trades at the imminence of news
announcements, albeit convex for small ones. Malik and Ng (2012) examine data from
HSBC and Next stocks traded at the London Stock Exchange and again find price
impacts to be concave for large trades and convex for smaller ones. Berger et al. (2008)
also find the price impact of order flow to be nonlinear in foreign exchange markets.
Within a real options framework, Chacko, Jurek, and Stafford (2008) show that a

monopolistic market maker optimally quotes nonlinear bid and ask schedules. They find
considerable empirical support for their model's predictions in the cross-section of
NYSE firms. Huang and Ting (2008) test a hyperbolic tangent price impact function to
find similar evidence for 1,748 stocks traded in the NYSE in 1997. Kempf and Korn
(1999) use neural networks to investigate intraday order flow and prices on German
index futures, concluding that the assumption of linear impacts of orders on prices is
highly questionable.
These divergences between theoretical assumptions and empirical evidence thus beg
the question of whether the assumption of linearity is truly necessary, or whether it is a
consequence of other assumptions. I examine what equilibrium demand schedules ought
to look like, once we widen the set of considered alternatives to all smooth investment
demand curves and find that, under CARA preferences and normally distributed returns,
they must indeed be linear.
On the other hand, the findings in the empirical literature of price impact functions as
nonlinear may indicate that, in the absence of other microstructure idiosyncrasies,
traders either do not have CARA preferences or that returns are non-Gaussian, or both.
Investment demand linearity is indeed a very strong assumption. I find that a linear
equilibrium is equivalent to traders being equally price sensitive regardless of any
endowment heterogeneity or information asymmetry. It is thus no surprise, as some of
the theoretical literature concludes, to find market depth to be irrelevant to price, once
either linearity or CARA-normal assumptions are in place.


3.3 Model
I introduce the standard benchmark case of Kyle (1989) in the appendix, against
which I compare the following specification. As in the standard case, a two-period
economy of N traders indexed by i {1,K , N} reallocate their wealth from an initial
cash balance xi remunerated at a riskless return r > 0, and holdings yi of a risky security
with a normally distributed liquidation value v, with mean and variance 2. I now
depart from that benchmark case by assuming that these investors are risk neutral rather
than risk averse. Risk neutrality here implies that the following solution applies to any
risk distribution of the security.
Let i ( p ) be the residual market demand function for trader i. Then market
clearing requires that:

i ( p ) + i ( p ) = 0 .


By inverting the market demand function, we have the price impact function from
trader is perspective:

p = (i )

( i ).


His optimal trading strategy i ( p ) is then given by:

i ( p ) = arg max E (1 + r )( xi p ) + ( yi + ) v p

= arg max (1 + r )( i )


( ))


The first order condition and the Inverse Function Theorem then yield the following
system of differential equations indexed by i:

i ( p ) = p
i ( p )
1+ r


Aggregating across i yields the ordinary differential equation for the aggregate
investment demand function:

( p ) = ( N 1) p
' ( p )
1+ r


The solution for equation (2.43) over the reals is:


1 + r N 1

( p ) = 1 2 I p >
p (0)
1 + r


where I is the indicator function and ( 0 ) gives the maximum number of securities
traders are willing to buy at a zero price. This is not unlike the CARA-Normal case, in
which the demand curve also intercepts the quantity axis at a finite number. The second
order condition of (2.41) implies that ( p ) is downward sloping; hence, ( 0 ) must be
Further, it establishes that most traders are willing to quote to one another, even as
the price approaches zero. This is counterintuitive at first, given that traders are risk
neutral. Once we consider that traders act strategically in this setting, and thus are
cognisant of the impact their quote has in the traded price, it becomes clear this is so.
To illustrate this effect I plot in Figure 3.1 both the risk-neutral and the CARANormal cases with N = 4 traders, r = 0 , = 1 , = 1 and ( 0 ) = 0.63 with price p on


the x-axis and aggregate demand ( p ) on the y-axis. With this specification the
equilibrium aggregate demand function is ( p ) = 0.63 3 1 p :

q (p)















Figure 3.1 Aggregate pricing schedules of CARA and risk neutral traders,

N = 4, ( 0) = 0.63, = 0.25, = 2, r = 0%.

The curvature of the limit order book is given by the number of traders N. Since

( 0 ) is positive, we take the second derivative of equation (2.44), and observe that the
pricing schedule is concave for p <

"( p ) =

1+ r

, convex for p >

N 2 1+ r 1+ r
( N 1)

N 1

1+ r

, and linear around zero:

(0) .


This is what produces the S-shape above and it supports the empirical findings of
Kraus and Stoll (1972), Hasbrouck (1991), and Keim and Madhavan (1996). Further, its


S-shape is very much in line with the hyperbolic tangent price impact function Huang
and Ting (2008) confirmed of the stocks traded in the NYSE. In effect the S-shape of
the demand schedule produces narrower spreads for small volumes than in the CARA
case of linearity, and wider spreads for large volumes. In the example above the
transition occurs when p = 0.5 and p = 1.5 . I reproduce Figure 3.1 in Figure 3.2 below,
adding the spreads in the three cases. CARA are marked spreads with a dashed line.
Notice that the dashed box is outside the solid one for small volumes and outside it for
larger spreads. At p = 0.5 and p = 1.5 the solid and dashed boxes overlap.

q (p)

Bid-ask spread

















Figure 3.2 Spread differences between aggregate pricing schedules of CARA and risk
neutral traders, N = 4, ( 0 ) = 0.63, = 0.25, = 2, r = 0%.

Further, by taking the first derivative of the solution we observe the slope trends to
negative infinity, meaning that traders are price insensitive around the mid-point price

1+ r

. This holds close resemblance to what we observe in practice, where quoted bid-


ask spreads only become wider for large volumes which contrasts to the linear price
impact suggested by CARA preferences.
This contrast is greater as the number of players increases. As N increases, the
demand schedule ( p ) approaches the step function equal to ( 0 ) for p <

( 0 ) for p >

1+ r

1+ r

, and

. To verify that, we take the derivative of the slope ' ( p ) with

respect to N.

1+ r

1 + r 1 + r N 1
'( p) =
ln 1
p ( 0 )
1 +
( N 1) N 1


By finding the roots of equation (2.46), we find that ' ( p ) approaches 0 when


1+ r

e1 N and p >

1+ r

+ e1 N , and

As N increases, the interval narrows around

in the interval
e1 N ,
+ e1 N .
1+ r
1+ r

1+ r

, and obtain the step function. As the

market approaches a competitive one, traders become price takers and bid-ask spreads
collapse to zero.


q (p)

N = 16

















Figure 3.3 Aggregate pricing schedules of CARA and risk neutral traders,,

N {4,16, }, ( 0 ) = 1, = 0.25, = 2, r = 0%.

The consequence of this result is the concave behaviour observed by Kraus and Stoll
(1972), Hasbrouck (1991), and Keim and Madhavan (1996) for upstairs block trades at
the NYSE is evidence that upstairs traders are risk neutral. This may not necessarily be
the case, as risk neutrality implies concavity not the other way around, but the result
corroborates the empirical findings. Conversely, market microstructure models that
assume risk neutrality and demand linearity on the part of institutional investors may
bear inconsistencies.

3.4 Conclusions
This chapter demonstrates Kyles conjecture: investment demand schedules ought to
be linear and symmetric when traders have CARA preferences, and exogenous risk
factors are jointly normal. It is no longer necessary to make an ad hoc linearity
assumption, and it is now possible to uniquely characterise the nature of noncompetitive

trading equilibrium. I assume demand schedules to be smooth. This is far more

justifiable than the linearity assumption it replaces. Kyles results, and those of the
extensive literature that depend on linearity and/or symmetry, hold in the presence of
these assumptions. Finally, I show that by simply replacing CARA preferences with risk
neutrality, we obtain an S-shaped, nonlinear investment demand schedule in line with
the empirical literature.


Appendix A

Kyles Conjecture

I now trace back to the introduction on the assumption of linearity, and how it
propagated especially throughout the literature. In his seminal 1985 paper, Kyle
demonstrates the existence of a linear equilibrium in a market, where a risk neutral
informed trader and uninformed market makers trade strategically amongst themselves
and with noise traders. Solutions are confined to be linear by assumption through the
informed traders demand curve. Kyle (1989) extends this framework by making
explicit the assumption about traders limit order schedules, assuming risk preferences
to be of the CARA type, and all exogenous risk factors, (the asset liquidation value, the
noise traders demand, and informed traders uncertainty) to be jointly normal. He thus
shows there to be a unique Nash equilibrium of investment demand curves amongst
linear demand schedules. Indeed, in Kyle (1989), he writes:
In the existence part of the result, the strategy functions are not merely best linear
strategies. Instead, the linearity of the strategies is a derived result in the sense that
for each speculator, the equilibrium linear strategy dominates all nonlinear
alternatives. In the uniqueness part of the result, linearity is a constraint. This paper
does not investigate whether equilibriums with nonlinear strategy functions exist.
In the uniqueness part of the theorem, symmetry is also a constraint. We conjecture
that the theorem could be generalized to remove this constraint by constructing a
proof which allows traders to conjecture linear strategy functions which differ from
trader to trader, then prove that they are all the same in equilibrium, but this is not
attempted here.

To restate, what he means by the equilibrium linear strategy dominates all nonlinear
alternatives while confirming that [the] paper does not investigate whether
equilibriums with nonlinear strategy functions exist is that a traders optimal trading
strategy is indeed linear, when faced with a linear residual supply curve. This follows


from market clearing, rather than from optimality. It is also a coherent assumption. If all
traders best response strategies are linear, then the residual supply curves they face
must indeed be linear. Kyles characterization of what his 1989 model does not
investigate is equally true of his 1985 paper and the recent extension of information
acquisition by agents (Kyle, Ou-Yang, and Wei (2011)). In the latter, the authors make
explicit the assumption that traders conjecture exclusively linear strategies. Nonlinear
equilibriums are ruled out by assumption.
It remains for one to show that, in this setting, equilibriums with nonlinear strategy
functions do not exist, and that the resulting linear equilibrium is symmetrical by
consequence of the models assumptions. Kyles intuition for his conjecture is clear and
convincing. Given the assumption that traders have CARA preferences and that all
exogenous risk factors are jointly normal, the traders expected utility turns out to be
quadratic on their trade quantities. This yields linear marginal utilities, or equivalently
linear demand schedules. Given these assumptions, I show Kyle's (1989) conjecture to
be correct for all smooth functions.12
Much of both the empirical and theoretical literature that followed from Kyles
framework assumes investment demand functions to be linear in prices, or equivalently
price impact functions to be linear in volume. Typically, the argument goes along the
lines of first assuming that each trader conjectures the other traders to be holding linear
demand schedules, or equivalently that the residual demand schedule is linear. It then
goes to show that each traders optimal schedule, in reaction to the residual demand
schedule is also linear. The argument does not actually show that equilibrium demand
curves ought to be linear amongst a wider class of alternative conjectures. It rather


We thank Alex Boulatov for pointing out a limitation of our original proof in an earlier version.


shows, by construction, the existence of an equilibrium amongst linear trading strategies

(see Pennacchi (2008) for an example).

CARA and Normality without Information Asymmetry

Here, I restate the benchmark case of Kyle (1989). Consider a two-period economy
of N traders indexed by i {1,K , N} , with CARA coefficient , allocating their wealth
wi between a balance xi in their savings accounts paying a constant riskless return r > 0
and holdings yi of a risky security, with a normally distributed liquidation value v, with
mean and variance 2.
Each trader i chooses to trade a quantity i ( p ) of the risky security at a price p to
maximize their expected utility over their terminal wealth which, by assumption, they
consume in its entirety at the period 1:

i ( p ) = arg max E exp ( ( (1 + r )( xi p ) + ( yi + ) v ) )

= arg max ( (1 + r ) p ) 12 2 ( yi + )


Contrary to the competitive case, these traders are cognizant of the impact of their
demand on prices. They realize that the demand for investment is elastic, and that higher
demand from buyers will compete with the remaining market demand at market clearing
and drive up prices. Similarly, a larger supply from sellers will have the opposite effect.
Traders are a priori agnostic of the market demand function, but, given their knowledge
of each others risk aversion, they will be able to derive it at the Nash equilibrium. This
I call a thin market.
Let i ( p ) be the residual market demand function for trader i. Market clearing then
requires that:


i ( p ) + i ( p ) = 0 .


By inverting the market demand function, we have the price impact function from
trader is perspective:

p = (i )

( i ).


Hence, we rewrite the traders portfolio optimization problem as:


i ( p ) = arg max (1 + r )( i )

( )) 12 2 ( yi + )


yielding, by the first order condition and the Inverse Function Theorem,

1+ r
1 (1 + r ) p
i ( p ) = 1 2 i ( p )



The next two propositions establish the logical equivalence between linear demand
schedules and homogenous price sensitivity in spite of endowment heterogeneity. This
is intuitive because, with CARA preferences, there are no wealth terms in the
equilibrium condition.
Proposition 3.1: If all traders demand schedules are linear, then they are all equally
price sensitive.
This is essentially the proof of Kyle's (1989) conjecture. By simply assuming each
trader to be differently price sensitive, we find by construction that equilibrium price
sensitivity coefficients are the same across all traders. Linearity thus implies symmetry.
Consequently, the assumption of symmetry is redundant.


Proposition 3.2: If all traders are equally price sensitive, then their investment
demand is linear.
This result shows the converse of the previous one. If one assumes symmetry,
linearity emerges. Both results together show the logical equivalence of symmetry and
linearity in this setting.
Proposition 3.3: If traders take account only of their own security holdings in setting
their optimal demand schedule, then they are equally price sensitive. Therefore,
equilibrium demand schedules are linear.13
Proposition 3.3 establishes that traders who take account only of private holdings,
and not of aggregate supply, are equally price sensitive. Their equilibrium demand
schedules are therefore linear, by Proposition 3.2.
Proposition 3.4: If demand schedules are smooth, then they are linear in equilibrium.
This is the main result of this section. It connects linearity and thus also symmetry to
the assumptions on CARA preferences and joint normality. In doing so, we identify
what assumptions need to be modified to better explain the nonlinearity observed
throughout the empirical literature.

CARA and Normality with Information Asymmetry

In this Section, I transfer the above results to the exact model setup and notation of
Kyle (1989). Consider a two-period pure exchange economy for a single risky security

with an uncertain value v%~ N 0, v1 , traded by N informed traders indexed by


This proposition and its proof are inspired by a suggestion made by Alex Boulatov, to whom we are


n {1,K , N} , M uninformed market makers indexed by m {1,K , M } , and noise

traders. Traders and market makers act as liquidity suppliers by submitting a schedule
of limit orders to the market, while noise traders act as liquidity demanders by

submitting random market orders ~ N 0, 2

that are independent of the assets

value. Both informed and uninformed traders are risk averse, and quote quantities xn(p)
and ym(p), respectively, for each given trade price p to maximize their exponential
utility over their trade profits, each with CARA coefficients I and U respectively:

n ( p ) = arg max E exp ( I ( v p ) x ) p, in ,

ym ( p ) = arg max E exp ( U ( v% p ) y ) p .



% %
Each informed trader n receives a private signal i%
n = v + en before they submit their

orders. All informed traders signal errors e%
1 ,K , eN are normally distributed with mean
zero and variance e1 , and independent amongst themselves and of v%and z%. Since
traders have CARA preferences, their initial endowments are irrelevant to pricing, and
thus normalize to zero.
At this point, I depart from Kyle (1989) by refraining to assume linearity of residual
supply curves and symmetry of limit order schedules. Instead, I introduce the following
notation to denote residual supply curves for both informed and uninformed traders:

n ( p ) = x j ( p ) + ym ( p ) + ,
j n

m ( p ) = xn ( p ) + yk ( p ) + .

k m



Let p% be the market clearing price, so that:

%* % %*
n ( p ) + x n ( p ) = 0, n,

ym ( p%* ) + y%
m ( p ) = 0, m.


As I will show, equilibrium demand schedules are elastic at any price point, and
residual supply curves thus yield unique market clearing prices through the following

% %*
p%* = x%
n xn ( p ) = y m ym ( p ) = 0, m, n.


Since both the true asset value and the error in each of the informed traders private
signal are normally and independently distributed, all traders utility maximization
reduces to a simple mean-variance quadratic optimization:

% %
% % 2
n ( p ) = arg max E v p, in p x 2 I var v p, in x ,

ym ( p ) = arg max E v%p p y 12 U var v%p y 2 .



While market clearing only holds at the equilibrium price, both informed and
uninformed traders design their order schedules for each price point conditional on it
turning out to be the market clearing price. We can thus replace p in (2.55) above for p
in (2.56):

% % %1
% % 2
n ( p ) = arg max E v p, in x n ( x ) x 2 I var v p, in x ,

ym ( p ) = arg max E v%p ym1 ( y ) y 12 U var v%p y 2 .




Using the Inverse Function Theorem, and denoting the markets aggregate demand
curve by z ( p ) , the first order conditions for the above imply:

) (E v%p, i% p ) ,
y ( p ) = ( var v%p ( z ( p ) y% ( p ) ) ) ( E v%p p ) .

% %
n ( p ) = I var v p, in ( z ( p ) xn ( p ) )

1 1

1 1



The next two propositions establish the logical equivalence between linearity and
symmetry of demand schedules, in spite of information asymmetry and heterogeneity.
Proposition 3.5: If all traders demand schedules are linear, then they are symmetric
amongst informed and uninformed traders.
This is a striking result, although the literature commonly assumes symmetry. It
means that all informed and uninformed traders are equally price sensitive amongst
themselves, regardless of their information. This, in part, follows from them having
CARA preferences. The other part is due to joint normality of exogenous risks. This
implies that their expectations of the liquidation value, conditional on the market
clearing price, are linear on that price, and that their conditional variances are constant.
By furthermore assuming their demand curves to be linear, we solve for the curves
slope coefficients. We find that the latter are independent of each traders information.
They are thus the same amongst each group. Therefore, Proposition 3.1 establishes that
in the presence of CARA preferences and joint normality, linearity of demand schedules
implies symmetry. Proposition 3.6 below establishes that the converse also holds.
Proposition 3.6: If all informed and uninformed traders demand schedules are
symmetric amongst each group, then their investment demand is linear.


When we do not assume symmetry explicitly, differently from what is done in Kyle
(1989), we derive it from linearity, as demonstrated by Proposition 3.5. Proposition 3.6
shows that one may as well assume symmetry and derive linearity from it. Together
with Proposition 3.5, Proposition 3.6 completes the equivalence between linearity and
symmetry. The argument here is that to make demand schedules symmetric, the slope of
the traders demand curves must be independent of their information, as this is what
distinguishes them from one another. We then substitute into the optimality condition a
demand schedule that is separable as the sum of a price function and an information
function. When we match coefficients, we find that the price functions must be linear.
Symmetry and linearity are therefore logically equivalent in this setting. This allows us
to interpret any contrary empirical findings, as possible counterevidence of Kyle
models base assumptions, namely on risk preferences and distributions. In fact, the
next result establishes that these assumptions are sufficient to yield linearity and thus
also symmetry.
Proposition 3.8: If investment demands are smooth around the market clearing price,
then they will be linear in equilibrium.
Proposition 3.8 further grounds the equivalence established by Propositions 3.5 and
3.6 into the models risk preferences and distributional assumptions. Essentially, it
demonstrates Kyles seminal intuition that quadratic preferences, resulting from CARA
and joint normality, would yield linear demand schedules. These are the formers
marginals implied from the first order condition for optimality.
Next, I demonstrate this to be also the case within the realm of all smooth functions.
These are certainly more general than the assumptions of the previous literature, namely
linearity. I demonstrate it by induction. I first take the quadratic case to show that


equilibrium demand schedules over all second-degree polynomials ought to be linear.

Like with the previous proofs, I show this by placing the candidate demand schedules
into the optimality condition of equation (2.42), and matching coefficients. I then
establish the induction step for any arbitrary degree L, showing that a polynomial of
degree L with zero coefficients at all powers beyond than 0 and 1, will also have a zero
coefficient at the L-th power. This concludes the proof, as it demonstrates that
equilibrium demand schedules within the domain of all polynomial schedules are
always linear.

Appendix B
Proof of Proposition 3.1: For each trader i, let i ( p ) = i + i p be his demand
function. Then, by rewriting,

1+ r
1 (1 + r ) p
i + i p = 1 2 ( i )



where = i is the aggregate marginal demand. By matching coefficients, we


find that i must satisfy:

i = ( i )

1+ r
2 .


Since equation (1) is independent of the endowment yi, all traders marginal demand

i must be the same:

i =

N 2 1+ r
, i.
N 1 2



Proof of Proposition 3.2: The only potential difference amongst traders may be
differences in their initial holdings of securities. Hence, if they are all equally price
sensitive, then we must be able to decompose their demand schedule for investment

i ( p ) into a price function f(p) and an endowment function g(y). Thus, rewriting
equation (2.43),

1+ r
1 (1 + r ) p
i ( p ) = f ( p ) + g ( yi ) = 1 2 ( N 1) f ' ( p )



This is only possible if f ( p ) is constant, i.e. i ( p ) is linear on p, so as to preclude

any mixed terms arising in which price and endowment are factors.
Proof of Proposition 3.3: If, for each i, i ( p ) does not depend on y-i, then i ( p ) is
also independent of all yj for all j, and i ( p ) can be written as

1+ r '
(1 + r ) p

i ( p ) = f ( p )
yi where f ( p ) = 1 2 i ( p ) .


i ( p ) = f ( p ) ( N 1)

' i ( p ) = f ' ( p ) ( N 1)

(1 + r ) p
yi and

(1 + r ) p
1+ r

( N 1) f ( p ) 2 .


The latter equality holds for all p only if f ( p ) 0 . Hence,

(1 + r ) p

i ( p ) =



for some constant , and equilibrium demands are therefore symmetric and linear.
Proof of Proposition 3.4: Taken across all traders, equation (2.43) amounts to a
system of nonlinear ordinary differential equations. In order to solve it, I make use of
the assumption that investment demands are infinitely differentiable at every price level
to represent them by a Taylor series around an arbitrary price point p :

( p p ) i( k ) ( p ).
k =0 k !

i ( p ) =


To show that investment demand is linear is to show that all terms ai,k for k {0, 1}
are equal to zero. I prove this by induction on a series of Taylor polynomials. Take first
the quadratic case:

i ( p ) = i ( p ) + ( p p )i' ( p ) + 12 ( p p ) i" ( p ).


By substituting into and rearranging terms, we have

i ( p ) + ( p p )i' ( p ) + 12 ( p p ) i" ( p ) + yi

(1 + r ) p

1 + r ( p ) + i ( p )( p p ) + 12 i ( p )( p p )
= 2 i

' i ( p ) + ( p p ) "i ( p )


By inspection, one can readily see in (2.65), that if coefficients on both sides match,
then both i" ( p ) and "i ( p ) must be zero. The induction step is noting that, if for any
M, { i" ( p ) , , i( M 1) ( p ) } are all identically equal to zero, then

i ( p ) + i' ( p )( p p ) + M1 ! i( M ) ( p )( p p ) + yi

(1 + r ) p

(M )
1 + r i ( p ) + i ( p )( p p ) + M1 ! i ( p )( p p )
M 1
' i ( p ) + ( M11)! ( iM ) ( p )( p p )



The same argument used in the quadratic case also applies. Thus, all coefficients
other than intercept and slope are zero, i.e. traders equilibrium demands are linear:

i ( p ) = i ( p ) + i' ( p )( p p ),


where the slope i' ( p ) is given by (1), and the intercept is:

i ( p ) =

N 2 (1 + r ) p
N 3


If p is taken to be the market clearing price,

p =

2 y
1+ r


where y is the average endowment, then

ai ,0 =

N 2
( y yi ) .
N 3


Proof of Proposition 3.5: For each informed trader n and uninformed trader m, let

n ( p ) = In + In p and ym ( p ) = Um + Um p be their demand schedules, respectively.
Then, rewriting equation (2.58):

%In + In p = I var v%p, i%

n ( In )

) ( E v%p, i% p ) ,
) ( E v%p p ) ,

1 1

Um + Um p = U var v%p ( Um )

1 1


where = Um + In is the aggregate marginal demand. Since v%%

, p* , i%
n are jointly

and E v%p are linear functions of p, and var v%p, i%

normal, E v%p, i%

var v%p are constants for any given p. Moreover, since i%
1 ,K , iN are identically

is the same regardless of the information i%

distributed, var v%p, i%
n of informed trader

n. Let:

E v%p, i%
n = I + Ip p + Ii in ,
E v%p = U + Up p%* ,

var v%p, i%
n =I ,

var v%p = U1.


Thus, by matching coefficients, we find that In and Um satisfy:

I I1 ( In ) = In 1 ( Ip 1) ,

U U1 ( Um ) = Um 1 ( Up 1) .


We note that the equations above are the same for m and n. Thus, all informed and
uninformed traders marginal demands In and Um are the same amongst each group:

1 + ( N 1)
In = I = Ip
, n,
I I1

1 + ( M 1)
= U = Up
, m.
I U1



Proof of Proposition 3.6: The only potential differences amongst informed traders
stem from their private information. Hence, if their demand is symmetric, then we must
be able to decompose each informed trader ns demand schedule for investment x%
n ( p)

( )

into a price function f ( p ) and an information function g i%

n . Furthermore, each
uninformed trader must have exactly the same demand schedule h ( p ) . Thus,


n ( p ) = f ( p ) + g ( in )

= I I1 ( N 1) f ' ( p )

) ( + ( 1) p + i%) ,
h ' ( p ) ) ( + ( 1) p ) .

1 1

ym ( p ) = h ( p ) = U U1 ( M 1)


Ii n

1 1



For both x%
and ym ( p ) , the only possible solution is given by constant f ' ( p )
n ( p)
and h ' ( p ) respectively, i.e. x%
n ( p ) and ym ( p ) are linear on p.
Proof of Proposition 3.7: Taken across all traders, equations in (2.43) amount to a
system of nonlinear ordinary differential equations. In order to solve the system, I make
use of the assumption that investment demands are infinitely differentiable almost
everywhere in order to represent them by their Taylor series around an arbitrary price
point p :

1 (k )

n ( p )( p p ) ,
k =0 k !

ym ( p ) = ym( k ) ( p )( p p ) .
k =0 k !

n ( p) =


To show that investment demand is linear is to show that all terms an,k for k {0, 1}
are equal to zero. We prove this by induction on a sequence of polynomials. The first
step of the induction is the quadratic case:

n ( p ) = xn ( p ) + xn ( p )( p p ) + 2 xn ( p )( p p ) ,


n ( p ) = x n ( p ) + x n ( p )( p p ) + 2 x n ( p )( p p ) ,

ym ( p ) = ym ( p ) + ym' ( p )( p p ) + 12 ym" ( p )( p p ) ,

y m ( p ) = y m ( p ) + y' m ( p )( p p ) + 12 y" m ( p )( p p ) .



By substitution and rearranging terms, we have:

( x%( p ) + x%( p )( p p ) +




n ( p )( p p )



( x%
n ( p ) + x n ( p )( p p ) )

) = + (

( p ) + ym' ( p )( p p ) + 12 ym" ( p )( p p )


( y' m ( p ) + y" m ( p )( p p ) )



1) p + Ii i%

+ ( Up 1) p.


By inspection, one can readily see, from equations in (2.78) above, that if polynomial
" "
coefficients for p on both sides are to match, then x%
n ( p ) , x n ( p ) , ym ( p ) , y m ( p ) must















( L)
( L)

{ x%
n ( p ) ,, xn ( p ) , ym ( p ) , ..., ym ( p ) } are all identically equal to zero, then:

( x%( p ) + x%( p )( p p ) + x% ( p )( p p ) )
x% p +
x% ( p )( p p ) ) = + ( 1) p + i%,
( )

( y ( p ) + y ( p )( p p ) + y ( p p ) )
y ( p )( p p ) ) = + ( 1) p,
( p ) +








( L 1)!

L 1 1

( L)


( L 1)!

( L)

( L)

( L)


Ii n

L 1 1



( L)

for which the same argument used in the quadratic case also applies for x%
n ( p),
( L)
( L)
( L)

n ( p ) , ym ( p ) , y m ( p ) .

Thus, all coefficients, other than intercept and slope, are zero, i.e. traders
equilibrium demands are linear:

% %'

n ( p ) = xn ( p ) + xn ( p )( p p ) ,
ym ( p ) = ym ( p ) + ym' ( p )( p p ) .



4 Perfectly Rational Financial Bubbles

Chapter Summary
I show how credit cycles can emerge without any exogenous shocks, simply by the
effects of endogenous money creation. Cycles of bubbles and crashes generate when
part of the population has unstable financial access. As this population at the margin
enters the credit market, by funding their investments, new money is created spurring an
asset bubble. Once in, their exit withdraws that additional liquidity, causing the market
to crash. A key contribution of this chapter is making entry and exit into the credit
market endogenous. As such, no exogenous risk is required in this model for the market
to remain in a perpetual cycle of booms and busts. The model provides key insights into
the asset and credit bubbles at the turn of the 21st century, and how to prevent them.


4.1 Introduction
The Austrian Business Cycle Theory (ABCT) was first put forward by Mises (1953
[1912]). It was later fleshed out and presented by Hayek (1932). ABCT postulates that
credit cycles are generated by excessive credit creation, which artificially lowers interest
rates, thereby inflating asset prices. The artificially inflated asset prices and low cost of
capital stimulate investors in making malinvestments which inevitably do not produce
the income to sustain the bubble. A market crash ensues.
A main criticism of ABCT is that it seems to presume that investors are not fully
rational; for if they were, they would not commit the folly of joining the bubble. In
equilibrium, the expectation of credit creation would simply raise asset prices today,
and the effect would simply be a change of numeraire. In other words, if everyone acts
rationally, money is neutral, i.e. its quantity does not affect allocations in the economy.
What Mises and Hayek wished to demonstrate was that, in fact, money is not neutral,
and that monetary policy has a material effect in the economy.
Friedman and Schwartz (1963) later agreed with Mises on the impact of monetary
policy in the economy. In their view, what caused the Great Depression was a
substantial reduction of the money supply. They find that what prolonged the Great
Depression, which ensued after the 1929 Crash, was the lack of prompt and decisive
action from the US Federal Reserve in providing liquidity when it was lacking in the
market (Friedman and Schwartz (1963)). Their view was that while the feedback loop of
illiquidity is cut, a liquidity injection has no lasting effects. Prices eventually rebalance
themselves, albeit at different nominal levels.


In order to address the rational expectations criticism, Hayek (1945) made a

counterargument. He argues that the price system is the main mechanism by which
entrepreneurs make investment decisions, for they cannot have complete knowledge of
all that happens in the economy. If prices are distorted, they are bound to make distorted
capital allocations. Essentially, it is a bounded rationality argument.
What Hayek and Mises did not have at hand was Nash's (1951) notion of a
noncooperative equilibrium, in which fully rational behaviour of individuals in the
economy may produce irrational behaviour in the aggregate. This is the missing piece in
their puzzle, which I offer in this chapter.
Not only do I demonstrate how individuals may act irrationally in aggregate, but I
also show how credit creation and destruction arises naturally in the economy from
endogenising market entry and exit. This is unlike what Hayek had in mind, for whom
the culprit of financial instability is the money printer, i.e. the central bank. In his view,
the government is the only entity capable of injecting liquidity into the economy. I show
in my model that a group of lenders will naturally create and retract liquidity into the
credit market even without the interference of an exogenous money authority. This is
not by their design, but a rational response to everyone elses actions in the economy.
I also show how the credit cycle arises simply for financial reasons. Part of von
Mises and Hayeks argument is that malinvestments are irreversible. They are
investments in production capacity expansion that cannot be undone. I do not require
such an assumption in my model, for it is set in a pure exchange economy. However,
the model could expand to a production economy with such effects, which would make
economic fluctuations even more severe.


In this sense, our model is akin to Minsky's (2008 [1986]) Financial Instability
Hypothesis, in which, like in ABCT, credit cycles may emerge without exogenous
shocks from the production sector, simply as a coordination failure in the financial
This Section introduces the general context, background history, and motivation for
the chapter. Section 2 grapples with the problem of defining financial bubbles and
makes explicit the definition in this chapter. Section 3 reviews the literature. Section 4
presents the model. Section 5 illustrates it with a sample calibration. Section 6 interprets
the model. Section 7 provides policy recommendations, and Section 8 concludes.

4.2 Capturing a Bubble

The very notion of a financial bubble is not yet well defined in the literature.
Different authors seem to apply the term differently. This is because of the difficulty in
demonstrating that a financial bubble can exist when agents in the economy are
perfectly rational. To some authors, financial bubbles can only be identified in hindsight
after they crash, as pre-crash prices are then clearly seen as abnormally elevated against
post-crash prices. I call this the backward-looking definition of financial bubbles. One
subscriber to this view is former US Federal Reserve Chairman, Alan Greenspan, who
testified in 2005 at the House Budget Committee that:
As events evolved, we recognized that, despite our suspicions, it was very
difficult to definitively identify a bubble until after the fact that is, when
its bursting confirmed its existence. (March 2, 2005, to House Budget
Another view is that financial bubbles are defined as assets being traded at negative
risk premiums in spite of full knowledge of the buyer. This is the forward-looking


definition of financial bubbles, for it relates to assets future returns rather than past
history of prices. This is the definition put forward by DeMarzo, Kaniel, and Kremer
(2008), and the one I adopt here.

4.3 Literature
Financial bubbles are indeed difficult to explain in an environment where investors
behave rationally. It stands to reason that no sane investor would wilfully join a market
bubble, only to have her investment wiped out by collapsing asset prices. Thus, a first
class of financial bubble models resorts to the assumption that investor rationality is
bounded. Amongst these, most notable are Scheinkman and Xiong (2003) and Abreu
and Brunnermeier (2003). Scheinkman and Xiong (2003) divide the market into
optimists and pessimists. A short selling constraint prevents pessimists from betting
against an overpriced asset, whom then reasonably decide to ride the bubble in hope of
offloading the asset soon after to an optimist. As with the arrival of new information,
optimists become pessimists, and pessimists become optimists. The continual role
reversal allows the bubble to perpetuate and keep floating asset prices above consensual
values. In Abreu and Brunnermeier (2003), rational arbitrageurs take advantage of
mispricing caused by the optimists, but their failure to synchronize their actions
prevents arbitrageurs from pulling their collective weight against an asset bubble. The
bubble thus grows until it bursts when a critical mass of arbitrageurs sells out.
An alternative explanation focuses on the word wilfully used above. A market
which investors can only access through financial intermediaries acting as investment
managers introduces agency problems. This is the cornerstone of a second class of
financial bubble models. Notably, Scharfstein and Stein (1990) demonstrate that
investment managers concerned with their reputations might choose to mimic the

behaviour of other managers and ignore their own information. Allen and Gorton (1993)
show how fund managers can churn bubbles, knowingly investing their less informed
clients money in overvalued assets, for as long as their skill remains unknown to them.
Not only will investment managers knowingly herd into a bubble due to the information
asymmetry between their clients and themselves, but Shleifer and Vishny (1997) also
demonstrate that their deflection from the herd, in attempting to benefit their clients
from long-run arbitrage opportunities, is severely limited, since funds will flow out of
their hands, if the bubble continues to grow against their bets.
In both of these cases, however, the presence of client investors in the market is
taken as a given, presumably on the assumption that they are oblivious of a bubble, or
that they have no other choice. The first of these assumptions is indeed reasonable:
retail investors are typically less informed about investment assets than professional
money managers. However, even sophisticated investors get burned by agency
misrepresentation, if not outright fraud, as evidenced in 2008 by Madoffs $50 billion
swindle. Some instances, as Swan, Lu, and Westerholm (2015) show to be the case in
the Finnish market, are simply due to the misalignment of institutional investors
compensation incentives. Thus, ignorance cannot be the only element at fault.
The second assumption that client investors have no other choice than to trust their
savings to professional money managers is clearly false in the ever growing availability
and affordability of electronic brokerage. Even in their absence, investors have the
option in most cases to pull their money out of the financial markets, and invest in real
assets. A case in which they cannot liquidate their investments is when subject to a
forced savings scheme, such as a government imposed pension plan. Nonetheless, even
in those circumstances, either the pension is held in low-risk assets, or investors have
the flexibility of reallocating their funds across asset classes. At last, while bounded

rationality and agency problems may induce bubbles in financial markets, it is more
disconcerting to find out that even in an economy with perfectly rational investors and
no agency problems, financial bubbles could still emerge. This is what I show in this
The model I present here belongs to a third class of financial bubble models
supported by investors relative wealth concerns. In this class of models, investors
willingly and knowingly join a financial bubble because they are concerned about their
social standing in relation to their peers. The idea of relative wealth concerns was first
introduced into economic analysis by Duesenberry (1949), and later into finance by
Abel (1990) as an exogenous specification that each investor not only prefers to
consume more, but also prefers to consume more than others. Bakshi and Chen (1996)
show that relative wealth concerns are relevant to asset pricing, as they may induce
higher volatility. DeMarzo, Kaniel, and Kremer (2008) demonstrate how relative wealth
concerns can be endogenously generated in equilibrium in a finite-horizon, overlappinggenerations economy, potentially producing a financial bubble. In their model, bubbles
emerge as a consequence of demographic change, as young investors flock to risky
assets in anticipation to the competition of an upcoming yet unborn generation.
My model extends DeMarzo, Kaniel, and Kremer (2008) to an infinite-horizon
economy with three classes of investors: lenders, borrowers and workers. As in their
model, I study the introduction into the market of a group of fresh borrowers that were
previously excluded (e.g., subprime borrowers). These are the workers in our model
which are initially excluded from the market, due to lack of credit. The possibility of
their inclusion, however, poses a threat to current borrowers, who compete amongst
themselves for a limited amount of credit and assets. As new borrowers are brought into
the market, as fresh loans are extended to them, lenders inject liquidity into the

economy, raising asset prices and lowering investment yields. In a Nash equilibrium,
this induces current borrowers to be concerned about their wealth relative to their peers,
since an increase in the wealth of others, in relation to their own, implies a deflated
ability to invest. They then pre-empt the emergence of new borrowers entering the
market, and flock to risky assets, thereby bidding up their prices. This, in turn, raises the
present value of workers wages, making them sufficiently creditworthy for lenders to
loan them money, thus fulfilling the old borrowers dreaded prophecy.
Once the workers are absorbed into the marketplace, the old borrowers become
concerned that they might be excluded from it again, if their peers sell out and asset
prices drop. Again, they pre-empt the move in prices, sell out their assets, causing prices
to plummet, eventually pushing workers out of the market. Liquidity retracts.
As the market swings up, risky assets rise relative to bonds, reducing the risk
premium and inducing what would be perceived in a rational expectations equilibrium
as lower risk aversion. The complete opposite happens on its way down. As borrowers
race amongst themselves to dump their risky assets, they act as if they had suddenly
become more risk averse. As the financial economy cycles between boom and bust in a
predator/prey-like dynamic equilibrium, wealth concentrates in the hands of those who
provide credit in the upturn and liquidity in the downturn.

4.4 Model
Consider an infinite-horizon exchange economy with labour income earned for the
production of a single nonstorable commodity. Everyone in this economy is risk averse
and has the same CRRA coefficient > 1, the same time-preference for consumption ,


and maximize their time-additive, expected discounted intertemporal utility v over

wealth, defined recursively through Bellmans equation:

(1 )
( c ( w) , ( w)) = arg( max


c1 + E v ( w%( c, ) ) w

+ E v w%( c ( w ) , ( w ) ) w

w = e + ( w c p ) R
w.p. 50%
w%( c, ) 0
w1 = e + ( w c p ) R + 2 w.p. 50%
v ( w ) = (1 ) c ( w )


There are two equally likely states: rain (1) or drought (0). Given their current wealth
w, they may choose their consumption c and either buy ( > 0) or short ( < 0) a oneperiod financial security, in net zero supply, at a price p that pays 2 if it rains, and 0 if it
does not. The wealth that is not consumed or invested is saved at a gross return R.
Alternatively, people may choose to borrow to fund their investment. People who work
can sell the product of their labour for a price p. These options then establish the
wealths law of motion above.
The first order conditions give us the marginal indirect utility over consumption in
both states of the world:

v ' ( w1 ) = p 1c

v ' ( w0 ) = ( 2 R 1 p ) 1c


Using the Envelope Theorem, we obtain that direct and indirect utility are
homothetic, as expected in a CRRA setting:

v ' ( w) = (1 + R 1 ) c ( w )



Taken together, (2.82) and (2.83) yield (2.84), showing us that the marginal rate of
substitution is constant, where c0 = c ( w0 ) and c1 = c ( w1 ) :

v ' ( w1 ) c1
= .
2 R p v ' ( w0 ) c0



We now introduce three classes of agents: lenders, borrowers, and workers denoted
by subscripts L, B, and W. Both workers and borrowers work, producing ! and !
commodity units, respectively. Lenders do not. Workers are unskilled, i.e. they are less
productive (! < ! ). There is no default, so everyone is able to lend and borrow at the
same gross market rate R, though they may only borrow if they own more than the
minimum wealth . This constraint encapsulates typical credit approval policies we
observe in practice, not only in financial institutions, but also as people lend to one
another. This is also a key element in driving the models results, as it is what causes
workers to included and excluded from the markets, as the economy cycles through
financial booms and busts.
If workers productivity is low enough, then a fall in prices may exclude them from
the financial market. As we shall see, that happens recurrently. This then creates two
regimes: one with, and one without the workers participation in the financial market.
When they do not participate, they will just consume their own production. We call the
first regime a bubble (U), and the second a crisis (D). At this point, the names of the
regimes do not imply anything in particular, but as we see later on, U is indeed a
financial bubble regime and D a financial crisis. We note that, since lenders do not
work, they purchase their consumption from borrowers in the crisis regime and from
borrowers and workers in the bubble regime. The market clears for both real and
financial assets, in each regime:

eB = cLD + cBD
eW + eB = cLU + cBU + cWU
0 = LD + BD
0 = LU + BU + WU



In the bubble regime workers can trade their production, thus expanding the market.
In the crisis regime, they cannot, and consume all they produce. Plugging in the
optimality condition for the lenders we obtain:

hD = ( 2 RD1 pD1 1)

hU = ( 2 R p 1)

1 1

eB cBD 0
eB cBD1

e + eB cWU 0 cBU 0
= W
eW + eB cWU 1 cBU 1


Here, the subscripts 1 and 0 refer again to the rain and drought states, respectively.
Since there is no production risk to share in the market, there is no reason why anyone
would trade financial contracts. Individuals would then consume their own production.
Prices would remain constant and lenders would go hungry. However, if we show that
people do trade, we will be establishing that they are engaging in sheer speculation. Let
us suppose borrowers do exactly that.
We let borrowers gamble a portion B of their next periods consumption. They bet

consumption units in one period and either come out better off with (1 + B ) cB in the
rain state, or worse off with (1 B ) cB in the drought state, where cB is their expected
consumption. Therefore, their budget constraints under both bubble and crisis are:

eB = (1 + ( RU pU 1) BU ) cBU
eB = (1 + ( RD pD 1) BD ) cBD


We now examine the bubble regime. As the workers know they will be pushed out of
the credit market, they choose their investment and consumption, knowing that they will
not be able to save in the next period and will have to consume it all. Their optimal
decision is thus given by:


( cW ,W ) = arg max (1 )

( c , )


+ Ew%( c, )


w = e + ( e c p ) R
w.p. 50%
w%( c, ) 0
w1 = e + ( e c p ) R + 2 w.p. 50%
Thus, their optimal consumption and investment policies in the bubble are:

(( R

pU ) h + pU



= pU + 2 ( hU 1) RU1 + pU hU






) (1 + R ) e


= 1 +



(1 + R ) e

Combining, (2.87), (2.89), the market clearing condition in (2.85) and the borrowers
bet BU , we can determine their expected consumption cBU , price pU and interest rate
RU :

= 1 RU pU + ( 12 ( hU 1) RU pU + 1) (1 + RU1 ) bU + 12 ( hU 1) ( (1 gU ) RU 1)


cBU = (1 + ( RU pU 1) BU ) eB



pU = 2 RU1 1 +

eB (1 + BU ) cBU + 1 (1 gU )(1 + RU ) + 2 (1 + RU ) eW



bU = 1 + 2 pU1 ( hU 1) RU1 + pU hU

gU = bU + 1 +


pU hU1 ( RU1 + 12 pU ( hU 1) )

We now determine BU by considering what is the best bet bU of a single borrower

given what are everyone elses bets, and find the Nash equilibrium. Given his bet, his
consumption cbU is (1 + bU ) cbU if it rains, and (1 bU ) cbU if it does not. His best bet
and consumption are thus given by:



= 1 + ( RU pU 1)( hU 1) ( gU 1)(1 + RU ) (1 + RU1 )


(1 RU pU ) eW

+ ( 12 ( hU 1) RU pU + 1) (1 + RU1 ) bU 12 ( hU 1) (1 + ( gU 1) RU )

BU = bU

= 1 + ( RU pU 1)( hU 1)

(( g

1)(1 + RU ) (1 + RU1 )



) ce


We now show that in the bubble there is a speculative Nash equilibrium in which
borrowers become bullish about possible rain and the security is traded at a negative
risk premium, i.e. the price pU is greater than the expected present value of its payoff

RU1 .
Theorem 4.1: There is a speculative equilibrium in which 2 < BU < 4 and


RU1 < pU < RU1 < 1.

Proof: We first assume that


RU1 < pU < RU1 < 1 and then notice that, given the

assumption, hU > 1 , cWU > 0 , WU < 0 , 0 < gU < 1 and 2 < BU < 4 . To verify that the
assumption is consistent with a solution we note that, given its implications, indeed:




< RU1 . (2.92)

2 RU < pU = 2 RU 1 +

eB (1 + BU ) cBU + 1 (1 gU )(1 + RU ) + 2 (1 + RU ) eW

4.5 Results
We now examine the behaviour of the model in a sample calibration, using the
following parameters:


Table 4.1




The wealth distribution is highly skewed to make a point. As seen in Table 4.2, while
lenders do not work (eL = 0), they are able to capture consumption both in a bubble and
in a crisis. They only go hungry at the competitive equilibrium, i.e. when borrowers do
not deviate, = 0, no one trades, and each one consumes their own production. While
borrowers are stuck in a Nash equilibrium, workers consume at the level that maximizes
their utility, given what they can afford. Below are optimal consumption and asset
holdings for a range of deviations from the competitive equilibrium.



Table 4.5












4.6 Interpretation
A key contribution of this model is endogenising the entry and exit of marginal
borrowers. Workers are offered credit when their income meets a minimum. If prices
rise in a bubble, so does the market value of their production. Even with their
productivity unchanged, they will be earning more and become eligible to borrow. If
that happens, new loans are issued and new financial contracts are underwritten. This
brings new liquidity into the market, which will eventually put downward pressure on
interest rates, therefore raising asset prices. Old borrowers, anticipating that this may
happen if workers are absorbed into the market, are savvy enough to place their bets on
a bull market. As none of them are the only clever borrower around, a bull market
ensues. The borrowers bull running effectively raises prices, indeed allowing workers
to meet credit eligibility.
The same logic applies to a bear market. Once workers are absorbed into the market,
the sheer possibility that they may be invited to leave and take the additional liquidity
with them, causes borrowers to run to the exits. Loans are unwound and assets are
liquidated at fire sale prices. On the other side of the bargain are the lenders. In this
model, lenders are modelled as a single agent, so they are not subject to the same
coordination failure, though this may be relaxed. While not working, lenders manage to
survive purely on banking. They loan to borrowers and workers on the way up, and
provide liquidity to rapidly depreciating assets on the way down.
I refer to this market anomaly as: dynamic market incompleteness. This is different
from standard market incompleteness, where risk cannot be fully shared across market
participants due to insufficiency of financial instruments. Market incompleteness exists
here because some participants are available to trade in some states of the world but not


others. This is essentially the same sort of market incompleteness Panageas, Kogan, and
Garleanu (2009) use to give an explanation for the equity premium and interest rate
puzzles, though they do not pursue the relative wealth concerns path.
Under dynamic market incompleteness, the financial market essentially becomes a
very large pyramid scheme. A cycle of bubbles and crashes is sustained by a portion of
the population pulled in and out of the market. While in most pyramid schemes, a strong
psychological effect is played on those who are lured into it, I show here that an
individuals decision to join the bubble can be fully rational, albeit suboptimal in
aggregate. The absorption of workers into the market then expands the money supply.
By conceding them credit, lenders are essentially creating money, which is then
reflected on the price of goods and assets. The bubble behaviour this model describes is
thus tantamount to asset inflation.

4.7 Prudential Regulation

The results from the model presented here have interesting policy implications. By
pointing to unstable financial access as the culprit of financial market disequilibrium, it
may be of interest for the stability of the financial economy that access to financial
products and services is stable. Essentially, this means that prudential authorities cannot
only focus on the amount lenders are loaning, but also to whom. They ought to monitor
whether lenders are expanding their client base because of improvements in their risk
management technology, or simply because a tide of liquidity is lifting all boats.

4.8 Conclusions
This chapter solves the problem of irrational behaviour towards financial bubbles,
without resorting to the assumption of irrationality on a part of the individuals.

Furthermore, it demonstrates how a cycle of asset bubbles and bursts may plague the
economy through the introduction of dynamic market incompleteness. The model
demonstrates how unstable financial access for a portion of the population can generate
pyramid-like behaviour, as the inflow of marginal participants sustains irrational
exuberance in a bull asset-inflating market, and the eventual outflow precipitates the
rush to the exits that is typical of financial crises. The model is suggestive of policy
solutions that stabilize financial access as a means of levelling the supply of credit,
prices and allocations in the economy.



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