Stochastic Interest Rates, Heterogeneous Valuations, and the Volatility-Volume Relation with Search Frictions

We propose a dynamic equilibrium model with stochastic interest rates in which agents hold heterogeneous valuations for the same asset and take on positions against each other. The model shows that interest rate uncertainty and investor heterogeneity are key determinants of price dispersion. Higher search intensity reduces price dispersion, while raising volume, leading to a negative volatility-volume relation. The sensitivity of volatility to volume is high when liquidity is low, interest rate variations are high and investors’ valuations are more heterogeneous. Evidence supports our model’s predictions and shows that search frictions play an important role in driving the volatility-volume relation. (JEL G12, G13) Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.