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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. Grossman, S.J. & Miller, M.H., 1988. "Liquidity And Market Structure," Papers 88, Princeton, Department of Economics - Financial Research Center.
  2. 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.
  3. Pierre-Olivier Weill & Dimitri Vayanos, 2007. "A Search-Based Theory of the On-the-Run Phenomenon," FMG Discussion Papers dp577, Financial Markets Group.
  4. 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.
  5. Ricardo Lagos & Guillaume Rocheteau, 2006. "Search in asset markets," Staff Report 375, Federal Reserve Bank of Minneapolis.
  6. Halkin, Hubert, 1974. "Necessary Conditions for Optimal Control Problems with Infinite Horizons," Econometrica, Econometric Society, vol. 42(2), pages 267-72, March.
  7. 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.
  8. 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.
  9. 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.
  10. 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.
  11. 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.
  12. 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.
  13. 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.
  14. Claudio E. V. Borio, 2004. "Market distress and vanishing liquidity: anatomy and policy options," BIS Working Papers 158, Bank for International Settlements.
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