Recognizability and Liquidity of Assets

Abstract

The recognizability of assets is embedded into a standard search model to determine liquidity returns. Assuming that money is universally recognizable but bond is not, two types of trades arise one where both money and bond are accepted and the other where only money is accepted as a medium of exchange-depending on a seller's strategy of accepting or rejecting the bond of unrecognized quality and a buyer's strategy of carrying the counterfeit bond. Equilibrium restrictions imply that the liquidity differentials between money and bond tend to increase with the recognizability problem. Money commands higher liquidity than bond by providing additional liquidity service when sellers reject the bond of unrecognized quality as well as when they recognize counterfeit bond. The coexistence of money and bond requires a higher full (liquidity augmented) return for bond than money, implying a positive liquidity premium.