Asset Classes

Abstract

This paper proposes a theory of endogenous differences in liquidity of assets based on the interaction between differences in their risk and differences in liquidity needs of agents. An equilibrium of the model displays a class structure, where agents sort themselves across different types of assets according to their types. High-liquidity-need agents hold on to safer portfolios than lower-liquidity-need agents whenever the variation in the value of liquidity across states raises the value of safe assets more than that of riskier assets, and vice versa. I also derive capital asset pricing model–like formulas for excess returns where the risk and liquidity premia are interdependent and specific to each type of agent.