Tuesday, November 27, 2012

Another liquidity-premium sighting - Harrison and Kreps

The word "moneyness" is synonymous with liquidity-premium. Both refer to that portion of an item's value that is derived from an individual's ability to sell it in the future.

I wrote about bitcoin's liquidity premium here, and here I talked about how QE affects the liquidity premium of the targeted asset.

Since it happens so rarely, it's always fun to see the idea of liquidity premiums pop up in academic literature. I was recently reading an old interview with Thomas Sargent in which he describes himself as “a Harrison-Kreps-Keynesian.” Here is Harrison and Kreps's paper (pdf), and here is the money quote:
We say that investors exhibit speculative behaviour if the right to resell a stock makes them willing to pay more for it than they would pay if obliged to hold it forever. This phenomenon will not occur in a world with one period remaining (as in the capital-asset-pricing model), in a world where all investors are identical, or in a world with complete and perfect contingency claims markets.
That's as good a description of a liquidity-premium as they come. Keynes was an early adopter of the idea of a liquidity premium, and presumably that's why Thomas Sargent is willing to call himself a Keynesian, at least in the Harrison-Kreps-Keynesian sense.  Another gem:
...investors attach a higher value to ownership of the stock than they do to ownership of the dividend stream that it generates, which is not an immediately palatable conclusion from a fundamentalist point of view... we suggest that this line of reasoning might lead to a "legitimate" theory of technical analysis.

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