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Liquidity and Market Crashes

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  • Jennifer Huang
  • Jiang Wang
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    Abstract

    In this paper, we develop an equilibrium model for stock market liquidity and its impact on asset prices when constant market presence is costly. We show that even when agents' trading needs are perfectly matched, costly market presence prevents them from synchronizing their trades and hence gives rise to endogenous order imbalances and the need for liquidity. Moreover, the endogenous liquidity need, when it occurs, is characterized by excessive selling of significant magnitudes. Such liquidity-driven selling leads to market crashes in the absence of any aggregate shocks. Finally, we show that illiquidity in the market leads to high expected returns, negative and asymmetric return serial correlation, and a positive relation between trading volume and future returns. We also propose new measures of liquidity based on its asymmetric impact on prices and demonstrate a negative relation between these measures and expected stock returns.

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    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 14013.

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    Date of creation: May 2008
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    Publication status: published as Jennifer Huang & Jiang Wang, 2009. "Liquidity and Market Crashes," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 22(7), pages 2407-2443, July.
    Handle: RePEc:nbr:nberwo:14013

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    Cited by:
    1. Gianni De Nicolò & Iryna Ivaschenko, 2009. "Global Liquidity, Risk Premiums and Growth Opportunities," CESifo Working Paper Series 2598, CESifo Group Munich.
    2. Gianni De Nicoló & Iryna V. Ivaschenko, 2009. "Global Liquidity, Risk Premiums and Growth Opportunities," IMF Working Papers 09/52, International Monetary Fund.

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