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:
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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)
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