Market Liquidity and Funding Liquidity

47 Pages Posted: 3 Nov 2008

See all articles by Markus K. Brunnermeier

Markus K. Brunnermeier

Princeton University - Department of Economics

Lasse Heje Pedersen

AQR Capital Management, LLC; Copenhagen Business School - Department of Finance; New York University (NYU); Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 4 versions of this paper

Date Written: August 2005

Abstract

We provide a model that links a security's market liquidity - i.e., the ease of trading it - and traders' funding liquidity - i.e., their availability of funds. Traders provide market liquidity and their ability to do so depends on their funding, that is, their capital and the margins charged by their financiers. In times of crisis, reductions in market liquidity and funding liquidity are mutually reinforcing, leading to a liquidity spiral. The model explains the empirically documented features that market liquidity (i) can suddenly dry up (i.e. is fragile), (ii) has commonality across securities, (iii) is related to volatility, (iv) experiences "flight to liquidity" events, and (v) comoves with the market. Finally, the model showshow the Fed can improve current market liquidity by committing to improve funding in a potential future crisis.

Keywords: Liquidity Risk Management, Liquidity, Liquidation, Systemic Risk, Leverage, Margins, Haircuts

Suggested Citation

Brunnermeier, Markus Konrad and Pedersen, Lasse Heje, Market Liquidity and Funding Liquidity (August 2005). NYU Working Paper No. SC-AM-05-06, Available at SSRN: https://ssrn.com/abstract=1294630

Markus Konrad Brunnermeier (Contact Author)

Princeton University - Department of Economics ( email )

Bendheim Center for Finance
Princeton, NJ
United States
609-258-4050 (Phone)
609-258-0771 (Fax)

HOME PAGE: http://www.princeton.edu/¡­markus

Lasse Heje Pedersen

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

Copenhagen Business School - Department of Finance ( email )

Solbjerg Plads 3
Frederiksberg, DK-2000
Denmark

New York University (NYU) ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom