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Liquidity Black Holes

Traders with short horizons and privately known trading limits interact in a market for a risky asset. Risk-averse, long horizon traders supply a downward sloping residual demand curve that face the short-horizon traders. When the price falls close to the trading limits of the short horizon traders, selling of the risky asset by any trader increases the incentives for others to sell. Sales become mutually reinforcing among the short term traders, and payoffs analogous to a bank run are generated. A "liquidity black hole" is the analogue of the run outcome in a bank run model. Short horizon traders sell because others sell. Using global game techniques, this paper solves for the unique trigger point at which the liquidity black hole comes into existence. Empirical implications include the sharp V-shaped pattern in prices around the time of the liquidity black hole.

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Paper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 1434.

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Length: 26 pages
Date of creation: Sep 2003
Publication status: Published in Review of Finance (2004), 8(1): 1-18
Handle: RePEc:cwl:cwldpp:1434
Note: CFP 1114.
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