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Illiquidity Contagion and Liquidity Crashes

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  • Giovanni Cespa
  • Thierry Foucault

Abstract

Liquidity providers often learn information about an asset from prices of other assets. We show that this generates a self-reinforcing positive relationship between price informativeness and liquidity. This relationship causes liquidity spillovers and is a source of fragility: a small drop in the liquidity of one asset can, through a feedback loop, result in a very large drop in market liquidity and price informativeness (a liquidity crash). This feedback loop provides a new explanation for comovements in liquidity and liquidity dry-ups. It also generates multiple equilibria.

Suggested Citation

  • Giovanni Cespa & Thierry Foucault, 2014. "Illiquidity Contagion and Liquidity Crashes," The Review of Financial Studies, Society for Financial Studies, vol. 27(6), pages 1615-1660.
    • Handle: RePEc:oup:rfinst:v:27:y:2014:i:6:p:1615-1660.
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    File URL: http://hdl.handle.net/10.1093/rfs/hhu016
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