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Liquidity and Financial Market Runs

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  • Antonio E. Bernardo
  • Ivo Welch

Abstract

We model a run on a financial market, in which each risk-neutral investor fears having to liquidate shares after a run, but before prices can recover back to fundamental values. To avoid having to possibly liquidate shares at the marginal postrun price—in which case the risk-averse market-making sector will already hold a lot of share inventory and thus be more reluctant to absorb additional shares—each investor may prefer selling today at the average in-run price, thereby causing the run itself. Liquidity runs and crises are not caused by liquidity shocks per se, but by the fear of future liquidity shocks.

Suggested Citation

  • Antonio E. Bernardo & Ivo Welch, 2004. "Liquidity and Financial Market Runs," The Quarterly Journal of Economics, Oxford University Press, vol. 119(1), pages 135-158.
  • Handle: RePEc:oup:qjecon:v:119:y:2004:i:1:p:135-158.
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    File URL: http://hdl.handle.net/10.1162/003355304772839542
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    1. Brennan, Michael J & Schwartz, Eduardo S, 1989. "Portfolio Insurance and Financial Market Equilibrium," The Journal of Business, University of Chicago Press, vol. 62(4), pages 455-472, October.
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    5. 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, vol. 98(4), pages 703-738, August.
    6. Basak, Suleyman, 1995. "A General Equilibrium Model of Portfolio Insurance," Review of Financial Studies, Society for Financial Studies, vol. 8(4), pages 1059-1090.
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