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Liquidity Black Holes

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  • Hyun Song Shin
  • Stephen Morris

Abstract

Traders with short horizons and privately known trading limits interact in a market for a risky asset. Risk-averse, long horizon traders supply a downward sloping residual demand curve that face the short-horizon traders. When the price falls close to the trading limits of the short horizon traders, selling of the risky asset by any trader increases the incentives for others to sell. Sales becomes strategic complements between the short term traders, and payoffs analogous to a bank run are generated. A "liquidity black hole" is the analogue of the run outcome in a bank run model. Short horizon traders sell because others sell. Using global game techniques, this paper solves for the unique trigger point at which the liquidity black hole comes into existence. Empirical implications include the sharp V-shaped pattern in prices around the time of the liquidity black hole

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Bibliographic Info

Paper provided by Econometric Society in its series Econometric Society 2004 North American Winter Meetings with number 620.

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Date of creation: 11 Aug 2004
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Handle: RePEc:ecm:nawm04:620

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Keywords: liquidity; global games;

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References

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  1. Markus K Brunnermeier & Lasse Heje Pederson, 2003. "Predatory Trading," FMG Discussion Papers dp441, Financial Markets Group.
  2. Stephen Morris & Hyun S Shin, 2001. "Global Games: Theory and Applications," Levine's Working Paper Archive 122247000000001080, David K. Levine.
  3. Gromb, Denis & Vayanos, Dimitri, 2002. "Equilibrium and welfare in markets with financially constrained arbitrageurs," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 361-407.
  4. Markus K Brunnermeier, 2002. "Bubbles and Crashes," FMG Discussion Papers dp401, Financial Markets Group.
  5. Viral V. Acharya & Lasse Heje Pedersen, 2004. "Asset Pricing with Liquidity Risk," NBER Working Papers 10814, National Bureau of Economic Research, Inc.
  6. Martin D. D. Evans & Richard K. Lyons, 2003. "How is Macro News Transmitted to Exchange Rates?," NBER Working Papers 9433, National Bureau of Economic Research, Inc.
  7. Hanno Lustig, 2001. "The Market Price of Aggregate Risk and the Wealth Distribution," Finance 0111004, EconWPA, revised 16 Nov 2001.
  8. Luboš Pástor & Robert F. Stambaugh, . "Liquidity Risk and Expected Stock Returns," CRSP working papers 531, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  9. Bengt Holmstrom & Jean Tirole, 1998. "LAPM: A Liquidity-based Asset Pricing Model," NBER Working Papers 6673, National Bureau of Economic Research, Inc.
  10. Max Bruche, 2002. "A structural model of corporate bond pricing with co-ordination failure," LSE Research Online Documents on Economics 24930, London School of Economics and Political Science, LSE Library.
  11. Morris, S & Song Shin, H, 1996. "Unique Equilibrium in a Model of Self-Fulfilling Currency Attacks," Economics Papers 126, Economics Group, Nuffield College, University of Oxford.
  12. Schnabel, Isabel & Shin, Hyun Song, 2001. "Foreshadowing LTCM: The Crisis of 1763," Sonderforschungsbereich 504 Publications 02-46, Sonderforschungsbereich 504, Universität Mannheim & Sonderforschungsbereich 504, University of Mannheim.
  13. Grossman, Sanford J & Miller, Merton H, 1988. " Liquidity and Market Structure," Journal of Finance, American Finance Association, vol. 43(3), pages 617-37, July.
  14. John Y. Campbell & Sanford J. Grossman & Jiang Wang, 1992. "Trading Volume and Serial Correlation in Stock Returns," NBER Working Papers 4193, National Bureau of Economic Research, Inc.
  15. Douglas W. Diamond & Raghuram G. Rajan, 2003. "Liquidity Shortages and Banking Crises," NBER Working Papers 10071, National Bureau of Economic Research, Inc.
  16. Andrei Shleifer & Robert W. Vishny, 1995. "The Limits of Arbitrage," NBER Working Papers 5167, National Bureau of Economic Research, Inc.
  17. Antonio E. Bernardo & Ivo Welch, 2002. "Financial Market Runs," NBER Working Papers 9251, National Bureau of Economic Research, Inc.
  18. Guillaume Plantin, 2003. "Self-Fulfilling Liquidity," FMG Discussion Papers dp448, Financial Markets Group.
  19. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June.
  20. Bengt Holmström, 2001. "LAPM: A Liquidity-Based Asset Pricing Model," Journal of Finance, American Finance Association, vol. 56(5), pages 1837-1867, October.
  21. Benjamin H. Cohen & Hyun Song Shin, 2003. "Positive feedback trading under stress: Evidence from the US Treasury securities market," BIS Working Papers 122, Bank for International Settlements.
  22. Danielsson, Jon & Shin, Hyun Song & Zigrand, Jean-Pierre, 2004. "The impact of risk regulation on price dynamics," Journal of Banking & Finance, Elsevier, vol. 28(5), pages 1069-1087, May.
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