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Liquidity, Default and Crashes: Endogenous Contracts in General Equilibrium

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    Abstract

    The possibility of default limits available liquidity. If the potential default draws nearer, a liquidity crisis may ensue, causing a crash in asset prices, even if the probability of default barely changes, and even if no defaults subsequently materialize. Introducing default and limited collateral into general equilibrium theory (GE) allows for a theory of endogenous contracts, including endogenous margin requirements on loans. This in turn allows GE to explain liquidity and liquidity crises in equilibrium. A formal definition of liquidity is presented. When new information raises the probability and shortens the horizon over which a fixed income asset may default, its drop in price may be much greater than its objective drop in value for two reasons: the drop in value reduces the relative wealth of its natural buyers and also endogenously raises the margin required for its purchase. The liquidity premium rises, and there may be spillovers in which other assets crash in price even though their probability of default did not change.

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    File URL: http://cowles.econ.yale.edu/P/cd/d13a/d1316.pdf
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    Bibliographic Info

    Paper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 1316.

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    Length: 35 pages
    Date of creation: Aug 2001
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    Publication status: Published in Advances in Economics and Econometrics, Vol. II, edited by M. Dewabtripont, L.P. Hansen and S.J. Turnovsky, 2003
    Handle: RePEc:cwl:cwldpp:1316

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    Related research

    Keywords: Liquidity; default; collateral; crashes; general equilibrium; contracts; spillover; liquidity premium;

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    1. John Moore & Nobuhiro Kiyotaki, . "Credit Cycles," Discussion Papers 1995-5, Edinburgh School of Economics, University of Edinburgh.
    2. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June.
    3. Smith, Vernon L, 1972. "Default Risk, Scale, and the Homemade Leverage Theorem," American Economic Review, American Economic Association, vol. 62(1), pages 66-76, March.
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    Cited by:
    1. Gromb, Denis & Vayanos, Dimitri, 2001. "Equilibrium and Welfare in Markets with Financially Constrained Arbitrageurs," CEPR Discussion Papers 3049, C.E.P.R. Discussion Papers.

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