Securities’ Liquidity under Uncertainty in Financial Intermediaries’ Liquidity

This paper investigates whether asset liquidity (i.e. the ease with which assets are traded) is determined by financial intermediaries’ liquidity (i.e. the funding that intermediaries provide). Unlike standard production-based asset pricing models where firms have access to external financing at some costs, we derive stock returns and stock liquidity under financial constraints of financial intermediaries. We show that the marginal funding provided by intermediaries is a factor not only for asset returns but also for asset liquidity. Using intermediaries’ balance sheet data from 1955 to 2009, we find support for the model predictions.