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Crashes and recoveries in illiquid markets

  • Ricardo Lagos
  • Guillaume Rocheteau
  • Pierre-Olivier Weill

We study the dynamics of liquidity provision by dealers during an asset market crash, described as a temporary negative shock to investors’ aggregate asset demand. We consider a class of dynamic market settings where dealers can trade continuously with each other, while trading between dealers and investors is subject to delays and involves bargaining. We derive conditions on fundamentals, such as preferences, market structure and the characteristics of the market crash (e.g., severity, persistence) under which dealers provide liquidity to investors following the crash. We also characterize the conditions under which dealers’ incentives to provide liquidity are consistent with market efficiency.

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Paper provided by Federal Reserve Bank of Cleveland in its series Working Paper with number 0708.

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Date of creation: 2007
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Handle: RePEc:fip:fedcwp:0708
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  1. Vayanos, Dimitri & Weill, Pierre-Olivier, 2006. "A Search-Based Theory of the On-the-Run Phenomenon," CEPR Discussion Papers 5965, C.E.P.R. Discussion Papers.
  2. Ricardo Lagos & Guillaume Rocheteau, 2006. "Search in Asset Markets," 2006 Meeting Papers 869, Society for Economic Dynamics.
  3. Ricardo Lagos & Guillaume Rocheteau, 2007. "Search in asset markets: market structure, liquidity, and welfare," Working Paper 0701, Federal Reserve Bank of Cleveland.
  4. Richard Lindsey & Anthony Pecora, 1998. "Ten Years After: Regulatory Developments in the Securities Markets Since the 1987 Market Break," Journal of Financial Services Research, Springer;Western Finance Association, vol. 13(3), pages 283-314, June.
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  8. Benveniste, L. M. & Scheinkman, J. A., 1982. "Duality theory for dynamic optimization models of economics: The continuous time case," Journal of Economic Theory, Elsevier, vol. 27(1), pages 1-19, June.
  9. Stoll, Hans R, 1978. "The Supply of Dealer Services in Securities Markets," Journal of Finance, American Finance Association, vol. 33(4), pages 1133-51, September.
  10. Michaely, Roni & Vila, Jean-Luc, 1996. "Trading Volume with Private Valuation: Evidence from the Ex-dividend Day," Review of Financial Studies, Society for Financial Studies, vol. 9(2), pages 471-509.
  11. 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.
  12. Ho, Thomas S Y & Stoll, Hans R, 1983. " The Dynamics of Dealer Markets under Competition," Journal of Finance, American Finance Association, vol. 38(4), pages 1053-74, September.
  13. Hamilton, James D, 1996. "The Daily Market for Federal Funds," Journal of Political Economy, University of Chicago Press, vol. 104(1), pages 26-56, February.
  14. Halkin, Hubert, 1974. "Necessary Conditions for Optimal Control Problems with Infinite Horizons," Econometrica, Econometric Society, vol. 42(2), pages 267-72, March.
  15. Claudio E. V. Borio, 2004. "Market distress and vanishing liquidity: anatomy and policy options," BIS Working Papers 158, Bank for International Settlements.
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