Search in Asset Markets

We investigate how trading frictions in asset markets affect portfolio choices, asset prices and efficiency. We generalize the search-theoretic model of financial intermediation of Duffie, Gârleanu and Pedersen (2005) to allow for more general preferences and idiosyncratic shock structure, unrestricted portfolio choices, aggregate uncertainty and entry of dealers. With a fixed measure of dealers, we show that a steady-state equilibrium exists and is unique, and provide a condition on preferences under which a reduction in trading frictions leads to an increase in the price of the asset. We also analyze the effects of trading frictions on bid-ask spreads, trade volume and the volatility of asset prices, and find that the asset allocation is constrained-inefficient unless investors have all the bargaining power in bilateral negotiations with dealers. We show that the dealers’ entry decision introduces a feedback that can give rise to multiple equilibria, and that free-entry equilibria are generically inefficient. ∗First version: October 2005. We are grateful to Pierre-Olivier Weill and Nicolae Gârleanu for many helpful conversations. We also thank seminar participants at the Federal Reserve Bank of Cleveland, Indiana University, Singapore Management University and the University of Pennsylvania for their comments. Financial support from the C.V. Starr Center for Applied Economics at NYU is gratefully acknowledged. Much of this research was conducted while Lagos was at the Minneapolis Fed and Rocheteau was visiting Penn. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Cleveland, the Federal Reserve Bank of Minneapolis or the Federal Reserve System.