Systemic Liquidation Risk and the Diversity-Diversification Trade-Off

87 Pages Posted: 29 Apr 2008 Last revised: 30 Oct 2010

See all articles by Wolf Wagner

Wolf Wagner

Erasmus University Rotterdam (EUR) - Rotterdam School of Management (RSM); Centre for Economic Policy Research (CEPR)

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

Wagner, Wolf, Systemic Liquidation Risk and the Diversity-Diversification Trade-Off (March 10, 2010). EFA 2009 Bergen Meetings Paper; AFA 2010 Atlanta Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1125588 or http://dx.doi.org/10.2139/ssrn.1125588

Wolf Wagner (Contact Author)

Erasmus University Rotterdam (EUR) - Rotterdam School of Management (RSM) ( email )

P.O. Box 1738
Room T08-21
3000 DR Rotterdam, 3000 DR
Netherlands

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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