Large Investors: Implications for Equilibrium Asset Returns, Shock Absorption, and Liquidity

We model illiquid asset markets where institutional investors account for their priceimpact when trading. The model explains why liquidity beta’s and market prices of liquidity-risk are time varying, and elevated during periods of market turbulence and heightened trading. We extend the distressed investor literature to a setting where all investors are optimizing, rational, and aware of distressed sales. Distressed sales cause pricing relationships to breakdown and front-running and predatory trading sometimes emerge, although in small amounts. We also introduce the concept ”market-structure of risk-bearing capacity”, and show it affects liquidity, the persistence of shocks to pricing relationships, and optimal liquidations.