Liquidity and Risk Management
AbstractThis paper provides a model of the interaction between risk-management practices and market liquidity. On one hand, tighter risk management reduces the maximum position an institution can take, thus the amount of liquidity it can offer to the market. On the other hand, risk managers can take into account that lower liquidity amplifies the effective risk of a position by lengthening the time it takes to sell it. The main result of the paper is that a feedback effect can arise: tighter risk management reduces liquidity, which in turn leads to tighter risk management, etc. This can help explain sudden drops in liquidity and, since liquidity is priced, in prices in connection with increased volatility or decreased risk-bearing capacity.
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Bibliographic InfoPaper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12887.
Date of creation: Feb 2007
Date of revision:
Publication status: published as Nicolae Gârleanu & Lasse Heje Pedersen, 2007. "Liquidity and Risk Management," American Economic Review, American Economic Association, vol. 97(2), pages 193-197, May.
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Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
Web page: http://www.nber.org
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Other versions of this item:
- G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
This paper has been announced in the following NEP Reports:
- NEP-ALL-2007-02-10 (All new papers)
- NEP-CFN-2007-02-10 (Corporate Finance)
- NEP-FMK-2007-02-10 (Financial Markets)
- NEP-RMG-2007-02-10 (Risk Management)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Pierre-Olivier Weill, 2007.
"Leaning Against the Wind,"
Review of Economic Studies,
Oxford University Press, vol. 74(4), pages 1329-1354.
- Markus K. Brunnermeier & Lasse Heje Pedersen, 2007.
"Market Liquidity and Funding Liquidity,"
NBER Working Papers
12939, National Bureau of Economic Research, Inc.
- Duffie, Darrell & Garleanu, Nicolae Bogdan & Pedersen, Lasse Heje, 2006.
"Valuation in Over-the-Counter Markets,"
CEPR Discussion Papers
5491, C.E.P.R. Discussion Papers.
- Darrell Duffie & Nicolae Garleanu & Lasse Heje Pedersen, 2004.
NBER Working Papers
10816, National Bureau of Economic Research, Inc.
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