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Liquidity and Risk Management

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Author Info
Nicolae B. Garleanu
Lasse H. Pedersen

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Abstract

This 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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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12887.

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Date of creation: Feb 2007
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Handle: RePEc:nbr:nberwo:12887

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G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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References listed on IDEAS
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.:
  1. Darrell Duffie & Nicolae Garleanu & Lasse Heje Pedersen, 2004. "Over-the-Counter Markets," NBER Working Papers 10816, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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    • Darrell Duffie & Nicolae Garleanu & Lasse Heje Pedersen, 2005. "Over-the-Counter Markets," Econometrica, Econometric Society, vol. 73(6), pages 1815-1847, November. [Downloadable!] (restricted)
  2. Darrell Duffie & Nicolae Garleanu & Lasse Heje Pedersen, 2006. "Valuation in Over-the-Counter Markets," NBER Working Papers 12020, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  3. Lasse Heje Pederson & Markus K Brunnermeier, 2007. "Market Liquidity and Funding Liquidity," FMG Discussion Papers dp580, Financial Markets Group. [Downloadable!] (restricted)
    Other versions:
  4. Pierre-Olivier Weill, 2007. "Leaning Against the Wind," Review of Economic Studies, Blackwell Publishing, vol. 74(4), pages 1329-1354, October. [Downloadable!] (restricted)
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Cited by:
(explanations, 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.)

  1. Chris D'Souza & Ingrid Lo & Stephen Sapp, 2007. "Price Formation and Liquidity Provision in Short-Term Fixed Income Markets," Working Papers 07-27, Bank of Canada. [Downloadable!]
  2. Topi, Jukka, 2008. "Bank runs, liquidity and credit risk," Research Discussion Papers 12/2008, Bank of Finland. [Downloadable!]
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