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Crashes and Recoveries in Illiquid Markets

  • Pierre-Olivier Weill

    ((UCLA))

  • Guillaume Rocheteau

    ((Cleveland Fed))

  • Ricardo Lagos

    ((NYU))

We study the dynamics of dealers' inventories during an asset market crash, described as a temporary, negative shock to outside investors' aggregate asset demand. We consider a class of dynamic market settings where trading between dealers and outside investors is subject to delays and requires bargaining. We show that dealers are more likely to accumulate inventories when the crash is severe and expected to be short-lived, when the elasticity of investors' asset demand is in some intermediate range, and when trading delays are neither too small nor too large. Giving dealers market power can either increase or decrease the equilibrium amount of inventory they accumulate, but will always reduce welfare.

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Paper provided by Society for Economic Dynamics in its series 2007 Meeting Papers with number 981.

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Date of creation: 2007
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Handle: RePEc:red:sed007:981
Contact details of provider: Postal: Society for Economic Dynamics Christian Zimmermann Economic Research Federal Reserve Bank of St. Louis PO Box 442 St. Louis MO 63166-0442 USA
Fax: 1-314-444-8731
Web page: http://www.EconomicDynamics.org/society.htmEmail:


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  1. Pierre-Olivier Weill & Dimitri Vayanos, 2007. "A Search-Based Theory of the On-the-Run Phenomenon," FMG Discussion Papers dp577, Financial Markets Group.
  2. Antonio E. Bernardo & Ivo Welch, 2004. "Liquidity and Financial Market Runs," The Quarterly Journal of Economics, MIT Press, vol. 119(1), pages 135-158, February.
  3. 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.
  4. Constantinides, George M, 1986. "Capital Market Equilibrium with Transaction Costs," Journal of Political Economy, University of Chicago Press, vol. 94(4), pages 842-62, August.
  5. Grossman, Sanford J & Miller, Merton H, 1988. " Liquidity and Market Structure," Journal of Finance, American Finance Association, vol. 43(3), pages 617-37, July.
  6. Andrew W. Lo & Harry Mamaysky & Jiang Wang, 2001. "Asset Prices and Trading Volume Under Fixed Transactions Costs," NBER Working Papers 8311, National Bureau of Economic Research, Inc.
  7. Ricardo Lagos & Guillaume Rocheteau, 2006. "Search in asset markets," Working Paper 0607, Federal Reserve Bank of Cleveland.
  8. Halkin, Hubert, 1974. "Necessary Conditions for Optimal Control Problems with Infinite Horizons," Econometrica, Econometric Society, vol. 42(2), pages 267-72, March.
  9. Ricardo Lagos & Guillaume Rocheteau, 2007. "Search in asset markets: market structure, liquidity, and welfare," Working Paper 0701, Federal Reserve Bank of Cleveland.
  10. Hans R. Stoll, . "The Supply of Dealer Services in Securities Markets," Rodney L. White Center for Financial Research Working Papers 2-78, Wharton School Rodney L. White Center for Financial Research.
  11. 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.
  12. 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, vol. 13(3), pages 283-314, June.
  13. Claudio E. V. Borio, 2004. "Market distress and vanishing liquidity: anatomy and policy options," BIS Working Papers 158, Bank for International Settlements.
  14. 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.
  15. 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.
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