Strategic Trading in Multiple Assets and the Effects on Market Volatiliy
We study government policies designed to increase liquidity by extending government guarantees to fundamentally illiquid assets. We characterize the effects of such policies on equilibrium price dynamics, trading strategies, and welfare. We build on the strategic trading framework of Brunnermeier and Pedersen (2005) and Carlin, Lobo, and Viswanathan (2007) by adding multiple assets and by modeling all agents’ utility functions. The assets in our model differ in their fundamental liquidity, i.e., the price reaction of the nonstrategic (or “retail”) traders to amounts sold by the strategic traders. Nonstrategic traders are willing to accept greater amounts of the more liquid asset with less short-term price reaction. These additions allow us to consider the welfare implications of, for example, shifting some assets from the illiquid category to the liquid category, a proxy for government guarantees on a risky asset. As in other models of this type, the strategic players “predate” on each other when one becomes distressed and is forced to liquidate its holdings. As others have shown, the more liquid the asset, the cheaper it is to predate on a distressed firm. Our model features an additional channel between liquidity and predation: because of the cross-elasiticies of demand across assets, firms can create liquidity in one asset by shorting a complementary asset. We find that when firms begin with larger endowments in highly liquid assets, forced liquidation of those assets tends to result in higher price volatility than would otherwise be the case. For plausible parameter ranges, such a policy also results in lower welfare for the nonstrategic traders. This finding suggests that market interventions designed to alleviate illiquidity in particular asset markets may instead unintentionally exacerbate price volatility.
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-1335, November.
- Kerry Back & C. Henry Cao & Gregory A. Willard, 2000. "Imperfect Competition among Informed Traders," Journal of Finance, American Finance Association, vol. 55(5), pages 2117-2155, October.
When requesting a correction, please mention this item's handle: RePEc:ijc:ijcjou:y:2009:q:4:a:8. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Bank for International Settlements)
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.