Illiquidity Contagion and Liquidity Crashes

Cespa, Giovanni; Foucault, Thierry

doi:10.2139/ssrn.1804351

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Illiquidity Contagion and Liquidity Crashes

72 Pages Posted: 8 Apr 2011 Last revised: 19 Feb 2014

See all articles by Giovanni Cespa

Giovanni Cespa

Bayes Business School; Bayes Business School; Centre for Economic Policy Research (CEPR)

Thierry Foucault

HEC Paris - Finance Department

There are 2 versions of this paper

Date Written: January 2014

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.

Keywords: Liquidity spillovers, Contagion, Liquidity Crashes, Multiple equilibria, Rational expectations

JEL Classification: G10, G12, G14

Suggested Citation: Suggested Citation

Cespa, Giovanni and Cespa, Giovanni and Foucault, Thierry, Illiquidity Contagion and Liquidity Crashes (January 2014). Available at SSRN: https://ssrn.com/abstract=1804351 or http://dx.doi.org/10.2139/ssrn.1804351