Systemic Liquidation Risk and the Diversity-Diversification Trade-Off
87 Pages Posted: 29 Apr 2008 Last revised: 30 Oct 2010
Date Written: March 10, 2010
Abstract
This paper proposes a portfolio choice model in which investors are subject to liquidation risk and face higher costs in the event of joint liquidation (as was observed during the crisis of 2008-2009). The risk of joint liquidation creates an incentive for investors to choose heterogenous portfolios and to rationally forego diversification benefits. In equilibrium, investors invest in all feasible portfolio allocations in the economy including the completely polarized ones. Joint liquidation risk is also reflected in asset prices, resulting in i) assets with high idiosyncratic risk having low expected returns and, ii), assets that display high correlation with the portfolios of (liquidation-prone) investors having high expected returns. I use the model to derive several unique predictions for how joint liquidation risk impacts both the cross-section of portfolio choices and asset prices.
Keywords: systemic liquidation risk, portfolio choice, asset pricing, heterogeneity, pricing of idiosyncratic risk
JEL Classification: G11, G12, G20, G33
Suggested Citation: Suggested Citation
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