Amplification of Uncertainty in Illiquid Markets

Abstract

This paper argues that the capacity of financial markets to aggregate information is diminished in times of distress, resulting in countercyclical economic uncertainty. I build upon a rational expectations equilibrium model that delivers this result from the combination of (i) countercyclical funding constraints faced by informed financial intermediaries, and (ii) the dispersed nature of information in the economy. During downturns, informed traders become increasingly exposed to non-fundamental price uctuations (noise trading risk), which reduces information-based trading and the informativeness of asset prices. Uncertainty can spike quite dramatically as conditions deteriorate due to amplification mechanisms that arise from the dispersed nature of information, and the presence of information externalities in a dynamic environment.I show that heightened uncertainty leads to increased risk premia, Sharpe ratios, and stock price volatility even when attitude towards risk and the unconditional volatility of fundamentals remain constant. I also trace the implications for real investment decisions when firms learn about productivity from the observation of stock prices: uncertainty affects welfare by reducing the accuracy of investment and also reduces its level as a precautionary response of firms. The mechanism outlined suggests that the success of public liquidity provision in stabilizing markets depends crucially on the distribution of liquidity across agents.