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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 National Bureau of Economic Research, Inc in its series NBER Working Papers with number 14119.

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Date of creation: Jun 2008
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Handle: RePEc:nbr:nberwo:14119

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  1. Antonio E. Bernardo & Ivo Welch, 2004. "Liquidity and Financial Market Runs," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 119(1), pages 135-158, February.
  2. 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.
  3. Hans R. Stoll, . "The Supply of Dealer Services in Securities Markets," Rodney L. White Center for Financial Research Working Papers, Wharton School Rodney L. White Center for Financial Research 02-78, Wharton School Rodney L. White Center for Financial Research.
  4. Dimitri Vayanos & Pierre-Olivier Weill, 2005. "A search-based theory of the on-the-run phenomenon," LSE Research Online Documents on Economics 459, London School of Economics and Political Science, LSE Library.
  5. Claudio E. V. Borio, 2004. "Market distress and vanishing liquidity: anatomy and policy options," BIS Working Papers 158, Bank for International Settlements.
  6. Ricardo Lagos & Guillaume Rocheteau, 2006. "Search in Asset Markets," 2006 Meeting Papers, Society for Economic Dynamics 869, Society for Economic Dynamics.
  7. Grossman, S.J. & Miller, M.H., 1988. "Liquidity And Market Structure," Papers, Princeton, Department of Economics - Financial Research Center 88, Princeton, Department of Economics - Financial Research Center.
  8. 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.
  9. Andrew W. Lo & Harry Mamaysky & Jiang Wang, 2004. "Asset Prices and Trading Volume under Fixed Transactions Costs," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 112(5), pages 1054-1090, October.
  10. Halkin, Hubert, 1974. "Necessary Conditions for Optimal Control Problems with Infinite Horizons," Econometrica, Econometric Society, Econometric Society, vol. 42(2), pages 267-72, March.
  11. 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.
  12. Hamilton, James D, 1996. "The Daily Market for Federal Funds," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 104(1), pages 26-56, February.
  13. Constantinides, George M, 1986. "Capital Market Equilibrium with Transaction Costs," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 94(4), pages 842-62, August.
  14. 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.
  15. 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.
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