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Forced Portfolio Liquidation

  • Ewerhart, C.
  • Valla, N.

We study the problem of a leveraged investor that is forced to unwind a significant fraction of its portfolio in a collection of illiquid markets. It is shown that markets may become disrupted in response to a relatively small liquidity shock. As a consequence, the probability of default can be much higher than suggested by standard risk measures. We also study the impact of successful liquidation on relative asset prices. Our analysis suggests that effective risk management of leveraged financial entities should focus on the entity's potential to generate emergency cash-flows net of third-party claims for liquidity.

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Paper provided by Banque de France in its series Working papers with number 179.

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Length: 33 pages
Date of creation: 2007
Date of revision:
Handle: RePEc:bfr:banfra:179
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  1. Acharya, Viral V & Pedersen, Lasse Heje, 2003. "Asset Pricing with Liquidity Risk," CEPR Discussion Papers 3749, C.E.P.R. Discussion Papers.
  2. Lubos Pastor & Robert F. Stambaugh, 2001. "Liquidity Risk and Expected Stock Returns," NBER Working Papers 8462, National Bureau of Economic Research, Inc.
  3. Markus K Brunnermeier & Lasse Heje Pederson, 2003. "Predatory Trading," FMG Discussion Papers dp441, Financial Markets Group.
  4. Dimitri Vayanos, 1998. "Transaction costs and asset prices : a dynamic equilibrium model," LSE Research Online Documents on Economics 451, London School of Economics and Political Science, LSE Library.
  5. Xiong, Wei, 2001. "Convergence trading with wealth effects: an amplification mechanism in financial markets," Journal of Financial Economics, Elsevier, vol. 62(2), pages 247-292, November.
  6. Jean-Luc Vila & Dimitri Vayanos, 1999. "Equilibrium interest rate and liquidity premium with transaction costs," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 13(3), pages 509-539.
  7. Albert S. Kyle, 2001. "Contagion as a Wealth Effect," Journal of Finance, American Finance Association, vol. 56(4), pages 1401-1440, 08.
  8. Grossman, Sanford J & Miller, Merton H, 1988. " Liquidity and Market Structure," Journal of Finance, American Finance Association, vol. 43(3), pages 617-37, July.
  9. Huang, Ming, 2003. "Liquidity shocks and equilibrium liquidity premia," Journal of Economic Theory, Elsevier, vol. 109(1), pages 104-129, March.
  10. Andrei Shleifer & Robert W. Vishny, 1995. "The Limits of Arbitrage," NBER Working Papers 5167, National Bureau of Economic Research, Inc.
  11. John Y. Campbell & Sanford J. Grossman & Jiang Wang, 1992. "Trading Volume and Serial Correlation in Stock Returns," NBER Working Papers 4193, National Bureau of Economic Research, Inc.
  12. Diamond, Douglas W & Verrecchia, Robert E, 1991. " Disclosure, Liquidity, and the Cost of Capital," Journal of Finance, American Finance Association, vol. 46(4), pages 1325-59, September.
  13. Greenwald, Bruce C. & Stein, Jeremy C., 1991. "Transactional Risk, Market Crashes, and the Role of Circuit Breakers," Scholarly Articles 3710666, Harvard University Department of Economics.
  14. Hellwig, Martin F., 1980. "On the aggregation of information in competitive markets," Journal of Economic Theory, Elsevier, vol. 22(3), pages 477-498, June.
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