Equilibrium Asset Pricing in the Presence of both Liquid and Illiquid Markets

I study a general equilibrium model in which investor’s hedge risks using two imperfectly correlated assets. The first asset is traded on a liquid market whereas the second is traded on an illiquid over-the-counter (OTC) market. The search and bargaining frictions on the OTC market combine with demand shocks to make the efficiency of the illiquid market time varying. This non-fundamental risk is priced, spills over, and increases the risk premium on the liquid asset. Furthermore, these frictions increase both the trading volume and the open interest on the liquid market. The liquid market both mitigates the frictions on the OTC market and captures some of the illiquid asset's value as a risk-sharing instrument. Each of these two effects can dominate and opening the liquid market has an ambiguous effect on the illiquid asset's expected returns. I link the model predictions to recent empirical findings.