| October 2023 |
Abstract
This paper studies the interplay between liquidity and fundamental risks in an asset pricing framework with a frictional, decentralized secondary market and endogenous trading decisions. In this setting, the liquidity value of assets decreases in the riskiness of the underlying. For a sufficiently large deterioration of fundamentals, agents stop trading the asset, leading to a freeze of the secondary market and flight-to-safety behavior. This mechanism implies a novel type of monetary “safe-trade” equilibrium, in which assets are traded if and only if safe. Liquidity feeds back into the default decision of the issuing firm, potentially leading to price spirals and a multiplicity of equity valuations and default thresholds.
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