Essays on liquidity in financial markets

This dissertation develops search-theoretic models that help explaining liquidity in financial markets. The first chapter studies equilibrium asset pricing and inventory strategies of marketmakers during a financial crisis in the face of a large and temporary external selling pressure, when order-execution delays prevent outside investors from trading continuously. I find that marketmakers provide liquidity over time to outside investors, by buying assets when the pressure is strong, accumulating inventories, and re-selling later on when the pressure has subsided. The inventory strategies of competitive marketmakers result in a Pareto efficient allocation, provided they have access to sufficient capital. If moral-hazard or adverse selection problems limit marketmakers' access to capital, there can be a policy role for lenient central-bank lending during financial disruptions. Lastly, the equilibrium allocation has features that policymakers would regard as symptoms of poor liquidity provision, but which are in fact consistent with efficiency. For example, the price jumps down at the time of the crash, suggesting that marketmakers should not be held responsible for smoothing large price declines during disruptions. The second chapter develops a search-based model of the cross-sectional distribution of asset returns, abstracting from risk premia and focusing exclusively on liquidity. A float-adjusted return model (FARM) is derived, explaining the pricing of liquidity with a simple linear formula: In equilibrium, the liquidity spread of an asset is proportional to the inverse of its free float, the portion of its market capitalization available for sale. This suggests that the free float is an appropriate measure of liquidity, consistent with the linear specifications commonly estimated in the empirical literature. The qualitative predictions of the model corroborate much of the empirical evidence.