ECON 4544 Risk and Liquidity in Financial Markets

Traditional Walrasian modeling of financial markets takes the view that fragmentation does not matter: it analyzes trading “as if” it were happening in a centralized marketplace in which a fictitious auctioneer provides all transaction services, instantly and at not cost. The search-and-matching approach runs counter to this view. It builds on the premise that trading occurs more slowly than commonly assumed, within many subgroups of investors exchanging subsets of tradable assets, and who make decisions based on partial information about aggregate conditions.
Perhaps the clearest example of a fragmented financial market is an over-the-counter (OTC) market such as the corporate bond market or markets for financial derivatives such as Credit Default Swaps, where investors have to contact each other by phone to bargain over the terms of trades. But even relatively centralized markets (e.g. electronic trading platforms such as Island) are fragmented because they do not simultaneously involve all potential asset holders. Finally, a commonly held view is that during financial disruptions, asset markets become more fragmented: because intermediaries have a harder time accessing the capital that would allow them to participate actively, outside investors find it more difficult to buy and sell assets.
In this class, we will cover recent advances in modeling fragmented financial market using search-and-matching techniques.



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