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Crashes and recoveries in illiquid markets

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  • Ricardo Lagos
  • Guillaume Rocheteau
  • Pierre-Olivier Weill

Abstract

We study the dynamics of liquidity provision by dealers during an asset market crash, described as a temporary negative shock to investors’ aggregate asset demand. We consider a class of dynamic market settings where dealers can trade continuously with each other, while trading between dealers and investors is subject to delays and involves bargaining. We derive conditions on fundamentals, such as preferences, market structure and the characteristics of the market crash (e.g., severity, persistence) under which dealers provide liquidity to investors following the crash. We also characterize the conditions under which dealers’ incentives to provide liquidity are consistent with market efficiency.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Cleveland in its series Working Paper with number 0708.

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Date of creation: 2007
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Handle: RePEc:fip:fedcwp:0708

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Keywords: Asset pricing ; Portfolio management ; Financial crises ; Liquidity (Economics);

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  1. Stoll, Hans R, 1978. "The Supply of Dealer Services in Securities Markets," Journal of Finance, American Finance Association, vol. 33(4), pages 1133-51, September.
  2. Ricardo Lagos & Guillaume Rocheteau, 2006. "Search in Asset Markets," 2006 Meeting Papers 869, Society for Economic Dynamics.
  3. Benveniste, L. M. & Scheinkman, J. A., 1982. "Duality theory for dynamic optimization models of economics: The continuous time case," Journal of Economic Theory, Elsevier, vol. 27(1), pages 1-19, June.
  4. Hamilton, James D, 1996. "The Daily Market for Federal Funds," Journal of Political Economy, University of Chicago Press, vol. 104(1), pages 26-56, February.
  5. Sanford J. Grossman & Merton H. Miller, 1988. "Liquidity and Market Structure," NBER Working Papers 2641, National Bureau of Economic Research, Inc.
  6. Andrew W. Lo & Harry Mamaysky & Jiang Wang, 2001. "Asset Prices and Trading Volume Under Fixed Transactions Costs," NBER Working Papers 8311, National Bureau of Economic Research, Inc.
  7. Dimitri Vayanos & Pierre-Olivier Weill, 2008. "A Search-Based Theory of the On-the-Run Phenomenon," Journal of Finance, American Finance Association, vol. 63(3), pages 1361-1398, 06.
  8. Richard Lindsey & Anthony Pecora, 1998. "Ten Years After: Regulatory Developments in the Securities Markets Since the 1987 Market Break," Journal of Financial Services Research, Springer, vol. 13(3), pages 283-314, June.
  9. Constantinides, George M, 1986. "Capital Market Equilibrium with Transaction Costs," Journal of Political Economy, University of Chicago Press, vol. 94(4), pages 842-62, August.
  10. Michaely, Roni & Vila, Jean-Luc, 1996. "Trading Volume with Private Valuation: Evidence from the Ex-dividend Day," Review of Financial Studies, Society for Financial Studies, vol. 9(2), pages 471-509.
  11. Claudio E. V. Borio, 2004. "Market distress and vanishing liquidity: anatomy and policy options," BIS Working Papers 158, Bank for International Settlements.
  12. Halkin, Hubert, 1974. "Necessary Conditions for Optimal Control Problems with Infinite Horizons," Econometrica, Econometric Society, vol. 42(2), pages 267-72, March.
  13. Ricardo Lagos & Guillaume Rocheteau, 2007. "Search in Asset Markets: Market Structure, Liquidity, and Welfare," American Economic Review, American Economic Association, vol. 97(2), pages 198-202, May.
  14. Antonio Bernardo & Ivo Welch, 2006. "Liquidity and Financial Market Runs," Yale School of Management Working Papers ysm280, Yale School of Management, revised 01 Aug 2003.
  15. Ho, Thomas S Y & Stoll, Hans R, 1983. " The Dynamics of Dealer Markets under Competition," Journal of Finance, American Finance Association, vol. 38(4), pages 1053-74, September.
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