We study the optimal trading strategy of mutual funds that face both position limits and differential illiquidity. We provide explicit characterization of the optimal trading strategy and conduct an extensive analytical and numerical analysis of the optimal trading strategy. We show that the optimal trading boundaries are increasing in both the lower and the upper position limits. We find that ...

Models with i.i.d. returns and perfect liquidity (e.g., Merton (1971)) suggest that after a stock price crash, investors should buy more stock. However, many investors sell stock to buy safe assets after a market crash (a “flight-to-quality”), even when market liquidity has significantly worsened. In this paper, we propose a tractable and flexible portfolio selection model where market crashes ...

This paper presents a theory, where managers can use the liquidity of securities as a choice variable to screen for “deep pocket” investors, those that have a low likelihood of facing a liquidity shock. We assume that there is information asymmetry about the quality of the manager between the existing investors and the market. The manager then faces a “lemons” problem when he has to raise funds...

This thesis consists of three essays in capital markets. The first essay presents a dynamic asset pricing model with heterogeneously informed agents. Unlike previous research, the general case where differential information leads to the problem of "forecasting the forecasts of others" and to non-trivial dynamics of higher order expectations is studied. In particular, it is proved that the model...

Several empirical studies report that asset liquidity has a significant impact on asset prices. For example, Amihud and Mendelson (1986), Silber (1991), Kadlec and McConnell (1994), and Brennan and Subrahmanyam (1996) report that stock prices are c.p. the lower, the lower stock liquidity is. For bond markets similar evidence is reported by Sarig and Warga (1989), Amihud and Mendelson (1991), Bo...

a r t i c l e i n f o This paper reexamines the liquidity effect on stock expected returns in the NYSE over the period 1926–2008, the pre-1963 period, for which there is a lack of research, and the post-1963 period. The results from the entire sample of 1926–2008 show that expected returns increase with the stock level illiquidity. However, illiquidity level has explanatory power in the cross-s...

We develop a structural bond valuation model to simultaneously capture liquidity and credit risk. Our model implies that renegotiation in financial distress is influenced by the illiquidity of the market for distressed debt. As default becomes more likely, the components of bond yield spreads attributable to illiquidity increase. When we consider finite maturity debt, we find decreasing and con...

We study an equilibrium in which agents face surprise liquidity shocks and invest in liquid and illiquid riskless assets. The random holding horizon from liquidity shocks makes the return of the illiquid security risky. The equilibrium premium for such risk depends on the constraint that agents face when borrowing against future income; it is insignificant without borrowing constraint, but can ...