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Illiquidity Contagion and Liquidity Crashes

Author

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  • Giovanni Cespa
  • Thierry Foucault

Abstract

Liquidity providers often learn information about an asset from prices of other assets. We show that this generates a self-reinforcing positive relationship between price informativeness and liquidity. This relationship causes liquidity spillovers and is a source of fragility: a small drop in the liquidity of one asset can, through a feedback loop, result in a very large drop in market liquidity and price informativeness (a liquidity crash). This feedback loop provides a new explanation for comovements in liquidity and liquidity dry-ups. It also generates multiple equilibria.

Suggested Citation

  • Giovanni Cespa & Thierry Foucault, 2014. "Illiquidity Contagion and Liquidity Crashes," Review of Financial Studies, Society for Financial Studies, vol. 27(6), pages 1615-1660.
  • Handle: RePEc:oup:rfinst:v:27:y:2014:i:6:p:1615-1660.
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    File URL: http://hdl.handle.net/10.1093/rfs/hhu016
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    Cited by:

    1. repec:bla:jfnres:v:39:y:2016:i:4:p:411-436 is not listed on IDEAS
    2. Itzhak Ben-David & Francesco A. Franzoni & Rabih Moussawi, 2016. "Exchange Traded Funds (ETFs)," Swiss Finance Institute Research Paper Series 16-64, Swiss Finance Institute.
    3. Giovanni Cespa & Xavier Vives, 2016. "High Frequency Trading and Fragility," CESifo Working Paper Series 6279, CESifo Group Munich.
    4. repec:eee:jbfina:v:87:y:2018:i:c:p:49-67 is not listed on IDEAS
    5. Petrescu, Monica & Wedow, Michael, 2017. "Dark pools in European equity markets: emergence, competition and implications," Occasional Paper Series 193, European Central Bank.
    6. Bank for International Settlements, 2016. "Regulatory change and monetary policy," CGFS Papers, Bank for International Settlements, number 55, December.
    7. Lescourret, Laurence & Moinas, Sophie, 2014. "Liquidity Supply across Multiple Trading Venues," TSE Working Papers 14-533, Toulouse School of Economics (TSE), revised Mar 2015.
    8. Nina Karnaukh & Angelo Ranaldo & Paul Söderlind, 2015. "Understanding FX Liquidity," Review of Financial Studies, Society for Financial Studies, vol. 28(11), pages 3073-3108.
    9. repec:eee:ecofin:v:44:y:2018:i:c:p:153-166 is not listed on IDEAS
    10. James Paulin & Anisoara Calinescu & Michael Wooldridge, 2018. "Understanding Flash Crash Contagion and Systemic Risk: A Micro-Macro Agent-Based Approach," Papers 1805.08454, arXiv.org.
    11. Broman, Markus S., 2016. "Liquidity, style investing and excess comovement of exchange-traded fund returns," Journal of Financial Markets, Elsevier, vol. 30(C), pages 27-53.
    12. repec:eee:pacfin:v:49:y:2018:i:c:p:164-199 is not listed on IDEAS
    13. Isaenko, Sergey, 2015. "Equilibrium theory of stock market crashes," Journal of Economic Dynamics and Control, Elsevier, vol. 60(C), pages 73-94.
    14. repec:kap:jrefec:v:56:y:2018:i:4:d:10.1007_s11146-017-9609-0 is not listed on IDEAS
    15. Isshaq, Zangina & Faff, Robert, 2016. "Does the uncertainty of firm-level fundamentals help explain cross-sectional differences in liquidity commonality?," Journal of Banking & Finance, Elsevier, vol. 68(C), pages 153-161.

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