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Liquidity and Risk Management

  • Nicolae Gârleanu
  • Lasse Heje Pedersen

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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Article provided by American Economic Association in its journal American Economic Review.

Volume (Year): 97 (2007)
Issue (Month): 2 (May)
Pages: 193-197

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Handle: RePEc:aea:aecrev:v:97:y:2007:i:2:p:193-197
Note: DOI: 10.1257/aer.97.2.193
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  1. Mitchel Y. Abolafia (ed.), 2005. "Markets," Books, Edward Elgar, number 2788, March.
  2. Darrell Duffie & Nicolae Gârleanu & Lasse Heje Pedersen, 2007. "Valuation in Over-the-Counter Markets," Review of Financial Studies, Society for Financial Studies, vol. 20(6), pages 1865-1900, November.
  3. Pierre-Olivier Weill, 2004. "Leaning against the wind," 2004 Meeting Papers 382, Society for Economic Dynamics.
  4. Markus K. Brunnermeier & Lasse Heje Pedersen, 2007. "Market Liquidity and Funding Liquidity," NBER Working Papers 12939, National Bureau of Economic Research, Inc.
  5. Darrell Duffie & Nicolae Garleanu & Lasse Heje Pedersen, 2005. "Over-the-Counter Markets," Econometrica, Econometric Society, vol. 73(6), pages 1815-1847, November.
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