Financial Market Runs
Our paper oï¿½ers a minimalist model of a run on a financial market. The prime ingredient is that each risk-neutral investor fears having to liquidate after a run, but before prices can recover back to fundamental values. During the run, only the risk-averse market-making sector is willing to absorb shares. To avoid having to possibly liquidate shares at the marginal post-run priceâ€”in which case the market-making sector will already hold a lot of share inventory and thus be more reluctant to absorb additional sharesâ€”all investors may prefer selling their shares into the market today at the average run price, thereby causing the run itself. Consequently, stock prices are low and risk is allocated ineciently. Liquidity runs and crises are not caused by liquidity shocks per se, but by the fear of future liquidity shocks.
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