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Market Runs: Liquidity and the Value of Information Klaus-Peter Hellwig and Shengxing Zhang New York University

April 6, 2013

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Motivation Why does market liquidity of opaque assets suddenly dry up during the crisis? market breakdown because of lemons problem exogenous change in asset quality “... in relation to the size of global financial markets, prospective subprime losses were clearly not large enough to account for the magnitude of the crisis.”, Bernanke (2010)

changes in beliefs exogenous information structure

changes in information structure because of information acquisition partial equilibrium analysis

introduction

model

steady states

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Motivation Why does market liquidity of opaque assets suddenly dry up during the crisis? market breakdown because of lemons problem exogenous change in asset quality “... in relation to the size of global financial markets, prospective subprime losses were clearly not large enough to account for the magnitude of the crisis.”, Bernanke (2010)

changes in beliefs exogenous information structure

changes in information structure because of information acquisition partial equilibrium analysis

model a dynamic lemons market with costly information acquisition to study the interaction of market liquidity asset value quality distribution incentives to acquire information

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Mechanism

This paper: costly information acquisition leads to multiple equilibria new illiquid equilibrium over-investment in information

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Mechanism

This paper: costly information acquisition leads to multiple equilibria new illiquid equilibrium over-investment in information

failure to internalize intertemporal externalities of information choices current information choice affect future choice through the quality distribution of asset supply (quality effect) future information choice affect current choice through the value of the asset (reputation effect)

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Literature

Dynamic lemons markets are fragile Camargo and Lester (2009) Guerrieri and Shimer (2011) Chiu and Koeppl (2011) (multiple equilibria)

Implication of endogenous information structure Dang, Gorton, Holmstrom (2009) Farhi, Tirole (2012)

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Setup

Continuous time, infinite horizon ( Duffie, Garleanu, Pedersen, 2005) A unit measure of investors Two types of assets: g , b durable, indivisible fixed supply: sg , sb , respectively each bearing a unit flow of fruits

Numeraire good deep pocket homogeneous valuation

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Setup

Preference flow utility from asset: uij · a ∈ R+ quality of asset: i ∈ {b, g } preference type: j ∈ {h, l } asset holding a ∈ {0, 1} uih − uil = d > 0,∀i ∈ {g , b}, ugh − ubh = q > 0

discount factor r preference shocks if a = 1, preference type h switch to type l with Poisson rate δ when a switches from 1 to 0, preference switch to h

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Setup

Decentralized bilateral market (over-the-counter) Investors meet randomly others with Poisson rate λ ∈ R++ the measure of investors of type: µgh , µgl , µbh , µbl , µn rate of meeting type x agents: 2λµx the meeting rate between type x and y : 2λµx µy

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Setup: the bargaining game Values: present value of the asset for buyers: Vgh , Vbh present value of the asset for sellers: Vgl , Vbl continuation value without an asset: Vn Vgj > Vbj , Vih > Vil , Vij > Vn , i ∈ {g , b}, j ∈ {h, l } Asset quality distribution: ratio of good asset supply over bad asset supply: ρ = probability that the asset is good:

µgl µbl

ρ 1+ρ

In the bargaining game: sellers have private information about the asset quality buyers have bargaining power buyers can learn privately the asset quality with cost C > 0

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Setup: the bargaining game

gain from trading with gl type: (Vgh + Vn ) − (Vgl + Vn ) = Vgh − Vgl with bl type: (Vbh + Vn ) − (Vbl + Vn ) = Vbh − Vbl

seller’s reservation price: Type gl : Pg = Vgl − Vn Type bl : Pb = Vbl − Vn < Pg Pg − Pb = Vgl − Vbl

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Bargaining game: buyer’s decisions ˆ the probability of acquiring information φ: ˆ the probability of offering Pg , conditional on no information ψ: acquired

ˆ ψˆ buyer’s actions can be summarized by φ,

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Bargaining game: offer choice ψˆ

max

ˆ ψ∈[0,1]

ψˆ ˆ +(1 − ψ)

h

1 h 1+ρ

(Vbh − Vbl ) + i 1 (V − V ) bh bl 1+ρ

ρ 1+ρ

(Vgh − Vgl ) −

1 1+ρ

Trade-off (Akerlof): ρ (Vgh − Vgl ) expected surplus from good assets: 1+ρ 1 expected information rent to bad assets: 1+ρ (Vgl − Vbl )

ψˆ summarized by ρ∗ =

Vgl −Vbl Vgh −Vgl

  , if ρ > ρ∗ = 1 ˆ ψ(t) ∈ [0, 1] , if ρ = ρ∗   =0 , if ρ < ρ∗

i (Vgl − Vbl )

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Bargaining game: information choice φˆ

φˆ ∈ [0, 1] maximizes h i ρ 1 φˆ 1+ρ (Vbh − Vbl ) + 1+ρ (Vgh − Vgl ) − C h i ) ( ˆ 1 (Vbh − Vbl ) + ρ (Vgh − Vgl ) − 1 (Vgl − Vbl ) ψ 1+ρ 1+ρ 1+ρ ˆ +(1 − φ) ˆ 1 (Vbh − Vbl ) +(1 − ψ) 1+ρ φˆ summarized by C ∗ ( C∗ =

1 1+ρ (Vgl − Vbl ), ρ 1+ρ (Vgh − Vgl ),

if ρ > ρ∗ , if ρ ≤ ρ∗ ,

1 (Vgl − Vbl ): 1+ρ ρ (Vgh − Vgl ): 1+ρ ∗

ψˆ = 1 ψˆ = 0

expected information rent expected gain from trade with type gl C is hump-shaped in ρ

  if C < C ∗ = 1 ˆ φ ∈ [0, 1] if C = C ∗   =0 if C > C ∗

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Dynamics: evolution of µ (the quality effects)

µ˙ bh (t) = −δµbh (t) +2λµn µbl (t) µ˙ bl (t) = δµbh (t) −2λµn µbl (t) µ˙ gh (t) = −δµgh (t) +2λµn µgl (t)[φ(t) + (1 − φ(t))ψ(t)] µ˙ gl (t) = δµgh (t) −2λµn µgl (t) [φ(t) + (1 − φ(t)) ψ(t)] | {z } quality effect Quality Effect: the externality of stage game equilibrium on future quality distribution φ(t) + (1 − φ(t)) ψ(t): probability that gl type seller accepts an offer

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Dynamics: evolution of V

rVgl (t) = ugl + V˙ gl (t) rVgh (t) = ugh + δ(Vgl (t) − Vgh (t)) + V˙ gh (t) rVbh (t) = ubh + δ(Vbl (t) − Vbh (t)) + V˙ bh (t) rVbl (t) = ubl + 2λµn (1 − φ(t))ψ(t) [Vgl (t) − Vbl (t)] + V˙ bl (t) {z } | reputation effect Reputation Effect: the externality of expected stage game equilibrium on asset value (1 − φ(t))ψ(t): probability of offering Pg Vgl (t) − Vbl (t) = Pg − Pb : information rent in combination: expected information rent from a stage game in the future

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Equilibrium

Definition A symmetric equilibrium is a path of outcomes {ψ, φ}, a path of distributions µ and a path of value functions V and initial condition µ(0) such that, given the initial condition , 1

given V (t) and µ(t), {ψ(t), φ(t)} solves a Subgame Perfect Nash Equilibrium of the bargaining game played at time t, ∀t,

2

given {ψ, φ}, µ is follows the laws of motion,

3

given {ψ, φ}, V satisfies the HJB equations.

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steady states: existence Lemma The steady state equilibrium is a fixed point of the following self-correspondence Γ on [0, 1] × [0, 1],   , if C < C ∗ (φ, ψ) 1 φˆ ∈ Γ1 (φ, ψ) = [0, 1] , if C = C ∗ (φ, ψ)   0 , if C > C ∗ (φ, ψ)   , if ρ(φ, ψ) > ρ∗ (φ, ψ) 1 ˆ ψ ∈ Γ2 (φ, ψ) = [0, 1] , if ρ(φ, ψ) = ρ∗ (φ, ψ)   0 , if ρ(φ, ψ) < ρ∗ (φ, ψ) By Kakutani Fixed Point Theorem, there exists a steady state equilibrium There may exist multiple steady states for given parameters Multiplicity and self-fulfilling market runs

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Fragility, information cost and asset quality

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φ = 0,ψ = 0 no learning, separating price φ = 0,ψ = 1 no learning, pooling price φ = 0,ψ ∈ (0, 1) no learning, mixed pricing φ = 1,ψ ∈ [0, 1] pure learning φ ∈ (0, 1),ψ = 0 partial learning, separating price φ ∈ (0, 1),ψ = 1 partial learning, pooling price φ ∈ (0, 1),ψ ∈ (0, 1) partial learning, mixed pricing

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Region without information acquisition

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φ = 0,ψ = 0 no learning, separating price φ = 0,ψ = 1 no learning, pooling price φ = 0,ψ ∈ (0, 1) no learning, mixed pricing φ = 1,ψ ∈ [0, 1] pure learning φ ∈ (0, 1),ψ = 0 partial learning, separating price φ ∈ (0, 1),ψ = 1 partial learning, pooling price φ ∈ (0, 1),ψ ∈ (0, 1) partial learning, mixed pricing

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Region with only information acquisition

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φ = 0,ψ = 0 no learning, separating price φ = 0,ψ = 1 no learning, pooling price φ = 0,ψ ∈ (0, 1) no learning, mixed pricing φ = 1,ψ ∈ [0, 1] pure learning φ ∈ (0, 1),ψ = 0 partial learning, separating price φ ∈ (0, 1),ψ = 1 partial learning, pooling price φ ∈ (0, 1),ψ ∈ (0, 1) partial learning, mixed pricing

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Region fragile to information acquisition

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φ = 0,ψ = 0 no learning, separating price φ = 0,ψ = 1 no learning, pooling price φ = 0,ψ ∈ (0, 1) no learning, mixed pricing φ = 1,ψ ∈ [0, 1] pure learning φ ∈ (0, 1),ψ = 0 partial learning, separating price φ ∈ (0, 1),ψ = 1 partial learning, pooling price φ ∈ (0, 1),ψ ∈ (0, 1) partial learning, mixed pricing

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Multiplicity between φ = 0, ψ = 0 and φ = 0, ψ = 1

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Multiplicity between φ = 0, ψ = 0 and φ = 0, ψ = 1

when C >

dq rd+q(r +δ) ,

no investors acquire information,

suppose there exists a separating equilibrium, V −V µ (ρ = µgl < ρ∗ = V gl −Vbl ) bl

gh

gl

as good asset is more likely to be traded (ψ ↑) quality effects: ψ ↑ ⇒ µgl ↓ ⇒ ρ ↓ reputation effect: ψ ↑ ⇒ Vbl ↑ ⇒ ρ∗ ↓ if pure pooling exists, reputation effect stronger ( ρ > ρ∗ )

Multiplicity exists if and only if δ > r Chiu and Koeppl (2012)

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Multiplicity between φ = 1, ψ ∈ [0, 1] and φ = 0, ψ = 1

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Multiplicity between φ = 1, ψ ∈ [0, 1] and φ = 0, ψ = 1

when quality is good enough, separating equilibrium ruled out suppose we start from φ = 0, ψ = 1 (pure pooling), where C > C ∗ as information acquisition becomes more likely (φ ↑): C ∗ = (1 − ρ)(Vgl − Vbl ), since ρ < ρ∗ reputation effect: φ(t) ↑ ⇒ Vbl (t) ↓ , ρ(−) ⇒ C ∗ ↑ if pure learning equilibrium exists, C < C ∗ when φ = 1.

liquid markets exhibit strategic complementarity in information choice quality effect shut down, the multiplicity always exists Fahri and Tirole (2012)

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Multiplicity between φ ∈ (0, 1), ψ = 0 and φ = 0, ψ = 1

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Multiplicity between φ ∈ (0, 1), ψ = 0 and φ = 0, ψ = 1

New illiquid equilibrium emerges The multiplicity region is larger when search friction is smaller

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Market runs: φ = 0, ψ = 1 −→ φ ∈ (0, 1), ψ = 0

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General liquidity dynamics

the transition path to a steady state may involve several discontinuous changes two types of discontinuous changes price only in both trade volume and price

two reasons for discontinuous changes shifts in expectation shifts in outcome of the stage game

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Social welfare

˙ rW = ugh µgh + ugl µgl + ubh µbh + ubl µbl − 2λµn (µbl + µgl )φC + W In steady state,

rW = ugh sg + ubh sb −

δ (d + 2λµn φC ) 2λµn + δ



2λµn + δ sg + sb 2λµn (φ + (1 − φ)ψ) + δ

When ψ = 1, information acquisition is always socially wasteful When ψ < 1, information acquisition may be welfare improving tradeoff: improving allocation vs information acquisition cost



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Private vs social cost of information when ψ = 0 and r ≈ 0, investors tend to over-invest in equilibrium with information acquisition Reason: when ρ < ρ∗ , social benefit from information acquisition ρ (Vgh − Vgl ) − C 1+ρ information acquisition decreases future ρ buyers fail to internalize the externality on distribution

By imposing a tax on information acquisition when φ ∈ (0, 1) the socially optimal φ∗ can be achieved, d

T = δ+δ

q

δ η(2λµn +δ)

d δC

 −C −1

T ↑ as search friction decreases or asset quality improves.

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Extensions

Information acquisition and market segmentation interaction of liquidity in two submarkets leads to fragility bilateral repo market and triparty repo market

information choice of asset owners

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Numerical Example Parameters

Endowments

sG sB

0.5 0.1

Dividends

g b δ

1.2 0.6 0.3

Discount rate

r

0.05

Poisson parameters

λ λu λd

20 1 1

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Extension: Bargaining power

So far: Buyer always makes offer Now: Seller makes offer with prob. q When seller makes offer, he proposes the buyer’s reservation price. P (seller = ρVgh + (1 − ρ)Vbh − Vnh , Vbh − Vnh , Cutoff value: ρ∗seller = (ρ∗buyer =

if ρVgh + (1 − ρ)Vbh − Vnh ≥ Vgl − Vnl otherwise

Vgl −Vnl −Vbh +Vnh

Vgl −Vbl Vgh −Vnh −Vbl +Vnl

Vgh −Vbh

)

The economy can have up to 4 equilibria with pure strategy steady states

Market Runs: Liquidity and the Value of Information

Apr 6, 2013 - Bernanke (2010) changes in beliefs exogenous information structure changes in information structure because of information acquisition partial equilibrium analysis model a dynamic lemons market with costly information acquisition to study the interaction of market liquidity asset value quality distribution.

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