Portfolio Choice and Pricing in Illiquid Markets - EFMA.pdfVIP

Portfolio Choice and Pricing in Illiquid Markets Nicolae Gˆarleanu∗ First Version: July 2004 This Version: April 2006 Abstract This paper studies portfolio choice and pricing in markets in which immediate trading may be impossible, such as the market for private equity and certain over-the-counter markets. Optimal positions are found to depend significantly and naturally on liquidity: when future liquidity is expected to be higher, agents take more extreme positions, given that they do not have to hold them for long when no longer desirable. Consequently, in markets with more frequent trading larger trades should be observed. The price, on the other hand, is not affected significantly by liquidity, due to the mitigating effect of endogenous position choice. Extensions with transaction costs, multiple assets, and heterogenous agents are considered among others. ∗Wharton School, University of Pennsylvania, 3620 Locust Walk, Philadelphia, PA 19104-6367, email garleanu@wharton.upenn.edu. I am grateful for discussions with Domenico Cuoco, Darrell Duffie, Rohit Rahi, Dimitri Vayanos, Pierre-Olivier Weill, and, especially, Lasse Pedersen, as well as for comments from seminar participants at Wharton and the ASAP conference at the LSE. I am solely responsible for all errors. 1 In many markets completing a trade may require a significant amount time. For in- stance, some investments, such as private equity, are essentially non-tradeable for cer- tain periods. Another example is the over-the-counter (OTC) markets, in which a large number of assets are trad