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Illiquidity Contagion and Liquidity Crashes

Author

Listed:
  • Giovanni Cespa

    (Cass Business School - City University London)

  • Thierry Foucault

    (GREGH - Groupement de Recherche et d'Etudes en Gestion à HEC - HEC Paris - Ecole des Hautes Etudes Commerciales - CNRS - Centre National de la Recherche Scientifique)

Abstract

Liquidity providers often learn information about an asset from prices of other assets. We show that this generates a self-reinforcing positive relationship between price informativeness and liquidity. This relationship causes liquidity spillovers and is a source of fragility: a small drop in the liquidity of one asset can, through a feedback loop, result in a very large drop in market liquidity and price informativeness (a liquidity crash). This feedback loop provides a new explanation for comovements in liquidity and liquidity dry-ups. It also generates multiple equilibria.

Suggested Citation

  • Giovanni Cespa & Thierry Foucault, 2014. "Illiquidity Contagion and Liquidity Crashes," Post-Print hal-00998274, HAL.
    • Handle: RePEc:hal:journl:hal-00998274
    DOI: 10.1093/rfs/hhu016
    as

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