Abstract:
Entrepreneurs need cash to finance their real investments. Since cash is costly to hold, entrepreneurs will underinvest. If entrepreneurs can access financial markets prior to learning about an investment opportunity, they can sell some of their less liquid assets for cash and, as a result, invest at a higher level. When financial markets are over-the-counter, the price that the entrepreneur receives for the assets that he sells depends on the amount of liquidity (cash) that is in the OTC market: Greater levels of liquidity lead to higher asset prices. Since asset prices are linked to liquidity, they can fluctuate over time even though asset fundamentals are fixed. Bid and ask prices naturally arise in an OTC market and the bid-ask spread is negatively correlated with asset returns when changes in asset prices are not related to changes in the OTC market structure. An increase in inflation widens bid-ask spreads and decreases asset prices
