The Trader's Dilemma: Trading Strategies and Endogenous Pricing in an Illiquid Market

Economics

Further details

We investigate a large trader's trading strategies in a search-based security market, in which all traders are subject to type switching. The large trader has pressure to liquidate her position by the end of the horizon to avoid extra holding costs and faces a tradeoff: if she trades quickly, she moves the price; if she trades slowly, she may not be able to find counterparties in the market. We show that there exists a subgame perfect equilibrium in which she chooses the optimal trading strategies taking into account both the price impact effect and liquidity uncertainty. Asset prices are generated endogenously through a dynamic search and bargaining process and reflect the impact of the large trader's trades. Small traders, who are price takers and possess no manipulating power, cannot be ignored because their reactions to the big trader's trading strategy jointly determine the market liquidity. We show that when market liquidity uncertainty is high, the large trader would rather put off trading because it is very costly to induce the small trader to undertake the liquidity risk. When the market liquidity uncertainty is very low, however, she unloads her position quickly despite the price impact incurred. Furthermore, we examine the two effects of liquidity uncertainty and imperfect competition on prices by studying three cases: the benchmark case, the case of a liquid market with a monopolist and the case of a competitive market with liquidity uncertainty. We show that the two effects on prices are nonlinear. When the market is perfectly liquid, there is no price impact from the large trader's quick trading; however, when the market is illiquid, and the large trader cannot discriminate across small traders, the large trader has to pay a discount for the liquidity uncertainty. Lastly, we explore limiting pricing results by extending the number of small traders and the number of trading periods and show that competitive intuition applies in the model.