A simple model of market liquidity

The literature on illiquid markets is relatively large although little theoretical work has been done in terms of endogenizing the liquidity problem. This paper presents a simple model in which Liquidity costs are entirely endogenous, i.e. the traders can technically trade at zero costs but in equilibrium these are incurred. The liquidity problem causes (i) the return on the asset to be greater, (ii) the volume of trade to be less, and (iii) the return on the asset to be more risky, than it otherwise would have been. All are characteristics associated with illiquid markets. (C) 1999 Elsevier Science S.A. All rights reserved.