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Liquidity and Risk Management

Author

Listed:
  • Nicolae Gârleanu
  • Lasse Heje Pedersen

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.
(This abstract was borrowed from another version of this item.)

Suggested Citation

  • Nicolae Gârleanu & Lasse Heje Pedersen, 2007. "Liquidity and Risk Management," American Economic Review, American Economic Association, vol. 97(2), pages 193-197, May.
    • 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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    References listed on IDEAS

    as
    1. Markus K. Brunnermeier & Lasse Heje Pedersen, 2009. "Market Liquidity and Funding Liquidity," The Review of Financial Studies, Society for Financial Studies, vol. 22(6), pages 2201-2238, June.
    2. Darrell Duffie & Nicolae Gârleanu & Lasse Heje Pedersen, 2007. "Valuation in Over-the-Counter Markets," The Review of Financial Studies, Society for Financial Studies, vol. 20(6), pages 1865-1900, November.
    3. Darrell Duffie, 2012. "Over-The-Counter Markets," Introductory Chapters, in: Dark Markets: Asset Pricing and Information Transmission in Over-the-Counter Markets, Princeton University Press.
    4. Mitchel Y. Abolafia (ed.), 2005. "Markets," Books, Edward Elgar Publishing, number 2788.
    5. Pierre-Olivier Weill, 2007. "Leaning Against the Wind," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 74(4), pages 1329-1354.
    Full references (including those not matched with items on IDEAS)

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    JEL classification:

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

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