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Financial Market Runs

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  • Antonio E. Bernardo
  • Ivo Welch

Abstract

Our paper offers a minimalist model of a run on a financial market. The prime ingredient is that each risk-neutral investor fears having to liquidate after a run, but before prices can recover back to fundamental values. During the urn, only the risk-averse market-making sector is willing to absorb shares. To avoid having to possibly liquidate shares at the marginal post-run price in which case the market-making sector will already hold a lot of share inventory and thus be more reluctant to absorb additional shares all investors may prefer selling their shares into the market today at the average run price, thereby causing the run itself. Consequently, stock prices are low and risk is allocated inefficiently. Liquidity runs and crises are not caused by liquidity shocks per se, but by the fear of future liquidity shocks.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 9251.

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Date of creation: Oct 2002
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Publication status: published as Bernardo, Antonio and Ivo Welch. "Liquidity and Financial Market Runs." Quarterly Journal of Economics 119-1 (February 2004): 135-158.
Handle: RePEc:nbr:nberwo:9251

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  1. James Dow & Gary Gorton, 1993. "Arbitrage Chains," NBER Working Papers 4314, National Bureau of Economic Research, Inc.
  2. De Long, J Bradford & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1990. "Noise Trader Risk in Financial Markets," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 98(4), pages 703-38, August.
  3. Ricardo J. Caballero & Arvind Krishnamurthy, 2001. "International Liquidity Illusion: On the Risks of Sterilization," NBER Working Papers 8141, National Bureau of Economic Research, Inc.
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  5. Markus K Brunnermeier, 2002. "Bubbles and Crashes," FMG Discussion Papers, Financial Markets Group dp401, Financial Markets Group.
  6. Basak, Suleyman, 1995. "A General Equilibrium Model of Portfolio Insurance," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 8(4), pages 1059-90.
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  8. Sushil Bikhchandani & David Hirshleifer & Ivo Welch, 2010. "A theory of Fads, Fashion, Custom and cultural change as informational Cascades," Levine's Working Paper Archive 1193, David K. Levine.
  9. Chowdhry, Bhagwan & Nanda, Vikram, 1998. "Leverage and Market Stability: The Role of Margin Rules and Price Limits," The Journal of Business, University of Chicago Press, University of Chicago Press, vol. 71(2), pages 179-210, April.
  10. Franklin Allen & Douglas Gale, 1998. "Financial Contagion Journal of Political Economy," Center for Financial Institutions Working Papers, Wharton School Center for Financial Institutions, University of Pennsylvania 98-31, Wharton School Center for Financial Institutions, University of Pennsylvania.
  11. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
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Cited by:
  1. Hyun Song Shin & Stephen Morris, 2004. "Liquidity Black Holes," Econometric Society 2004 North American Winter Meetings, Econometric Society 620, Econometric Society.

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