Asset pricing with imperfect competition and endogenous market liquidity

This thesis studies the effects of illiquidity in financial markets on expected asset returns in a model in which illiquidity stems from the strategic trading behavior of investors. For this purpose, the traditional concept of Walrasian equilibrium prices is replaced by the concept of Nash equilibrium in demand functions. This approach allows to integrate elements from market microstructure theory into the asset pricing analysis. The main result of the thesis is that trading costs in illiquid markets are - contrary to conventional wisdom - not reflected in liquidity premia on expected asset returns; instead, asset prices and expected returns are the same as in frictionless markets. This result holds in a static context and also in a dynamic model with additional trading costs and risks. The result is driven by the detailed modeling of investors' trading behavior in the market microstructure process