LIQUIDITY AS A CHOICE VARIABLE - A LESSON FROM THE JAPANESE GOVERNMENT BOND MARKET

In Japan, almost identical government bonds can trade at large price d ifferentials. Motivated by this phenomenon, we examine the issue of th e value of liquidity in markets for riskless securities. We develop a model of an issuer of bonds, a market maker, and heterogeneous investo rs trading in an incomplete market. We show not only that divergent pr ices for similar securities can be sustained in a rational expectation s equilibrium, but also that this divergence may be optimal from the p erspective of the issuer Price segmentation is possible because agents have a desire to trade, but short-sale restrictions limit their tradi ng strategies and prevent them from forcing bond prices to be equal. R estricting the form of market making to exclude price competition and unregulated profit maximization is also necessary to sustain price seg mentation. The optimality of segmentation from the issuer's standpoint arises because of the issuer's ability to charge for the liquidity se rvices provided to the investors.