[We analyze how asymmetric information and imperfect competition affect liquidity and asset prices. Our model has three periods: Agents are identical in the first, become heterogeneous and trade in the second, and consume asset payoffs in the third. We show that asymmetric information in the second period raises ex ante expected asset returns in the first, comparing both to the case where all private signals are made public and to that where private signals are not observed. Imperfect competition can instead lower expected returns. Each imperfection can move common measures of illiquidity in opposite directions.]

[This article studies the central role of the credit market. We show that the credit market facilitates optimal risk sharing by allowing less risk-averse investors to take on levered positions and consume more risk. The equilibrium amount behaves procyclically when aggregate consumption is low but countercyclically when it is high. The varying size of the credit market modifies the amount of risk sharing, which in turn influences asset prices such as expected stock returns, stock return volatility, and the term structure of interest rates. Our article provides a frictionless benchmark for the role and the behavior of the credit market.]

This article studies the central role of the credit market. We show that the credit market facilitates optimal risk sharing by allowing less risk-averse investors to take on levered positions and consume more risk. The equilibrium amount behaves procyclically when aggregate consumption is low but countercyclically when it is high. The varying size of the credit market modifies the amount of risk sharing, which in turn influences asset prices such as expected stock returns, stock return volatility, and the term structure of interest rates. Our article provides a frictionless benchmark for the role and the behavior of the credit market. The Author 2012. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: [email protected]., Oxford University Press.

We analyze how asymmetric information and imperfect competition affect liquidity and asset prices. Our model has three periods: Agents are identical in the first, become heterogeneous and trade in the second, and consume asset payoffs in the third. We show that asymmetric information in the second period raises ex ante expected asset returns in the first, comparing both to the case where all private signals are made public and to that where private signals are not observed. Imperfect competition can instead lower expected returns. Each imperfection can move common measures of illiquidity in opposite directions.