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Frictional Finance



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Frictional Finance Fricofinance Lasse H Pedersen NYU CEPR and NBER Copyright 2010 Lasse H Pedersen Frictional Finance Motivation In physics frictions are not important to certain phenomena but frictions are central to other phenomena Economists used to think financial markets are like dropping balls However as in aerodynamics the frictions are central to the dynamics of the financial markets Walrasian auctioneer Frictional Finance Lasse H Pedersen 2 Frictional Finance Implications Financial frictions affect Asset prices Macroeconomy business cycles and allocation across sectors Monetary policy Parsimonious model provides unified explanation of a wide variety of phenomena Empirical evidence is very strong Stronger than almost any other influence on the markets including systematic risk Frictional Finance Lasse H Pedersen 3 Frictional Finance Definitions Market liquidity risk Market liquidity ability to trade at low cost conversely market illiquidity trading cost Measured as bid ask spread or as market impact Market liquidity risk risk that trading costs will rise We will see there are 3 relevant liquidity betas Funding liquidity risk Funding liquidity for a security ability to borrow against that security Funding liquidity for an investor investor s availability of capital relative to his need Measured as the security s margin requirement or haircut Measured as Lagrange multiplier of margin constraint Funding liquidity risk risk of hitting margin constraint Happens if margin requirement increases or capital decreases Frictional Finance Lasse H Pedersen 4 Frictional Finance Overview Market liquidity risk Asset pricing Securities with more market liquidity risk have higher required returns Limits of arbitrage Evidence Stocks corporate bonds Treasuries Funding liquidity risk Asset pricing Macro economics Financial frictions affect business cycles and allocation of capital across sectors Monetary policy Securities with higher margins requirements have higher required



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