Illiquidity Contagion and Liquidity Crashes

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

Giovanni Cespa

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

Thierry Foucault

HEC Paris - Finance Department

Multiple version iconThere 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

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

Giovanni Cespa

Cass Business School ( email )

106, Bunhill Row
London, EC1Y 8TZ
Great Britain
+44(0)2040708704 (Phone)

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Thierry Foucault (Contact Author)

HEC Paris - Finance Department ( email )

1 rue de la Liberation
Jouy-en-Josas Cedex, 78351
France
(33)139679569 (Phone)
(33)139677085 (Fax)

HOME PAGE: http://thierryfoucault.com/

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