Illiquidity Contagion and Liquidity Crashes
Cass Business School; Centre for Economic Policy Research (CEPR)
HEC Paris - Finance Department
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.
Number of Pages in PDF File: 72
Keywords: Liquidity spillovers, Contagion, Liquidity Crashes, Multiple equilibria, Rational expectations
JEL Classification: G10, G12, G14
Date posted: April 8, 2011 ; Last revised: February 19, 2014