Asset Prices and Wealth Dynamics in a Financial Market with Endogenous Liquidation Risk

Abstract

Within a financial market where a risk-free bond and a long-lived risky asset are exchanged by investors with heterogeneous trading rules, we assume that the investors most exposed to the risky asset are subject to joint liquidation needs. The latter encompass a risk whenever the market impact of traders subject to them is large enough, due to a fire-sale phenomenon. Our aim is to provide conditions for the transformation of liquidation needs into liquidation risk, and to characterize the resulting asset price dynamics. We find that when the average position of traders subject to liquidation needs is lower than the position of the other traders, the former vanish and asset prices are driven solely by the dividend process. Whether liquidation risk becomes systemic or its impact is mitigated by the position of other traders, depends on the relative wealth dynamics. We provide conditions on agents positions under which the liquidation risk is always systemic because the aggressive traders dominate, as well as conditions under which the size of the liquidation risk is endogenously determined because all traders survive and the relative wealth dynamics is a mean reverting process.

Keywords: Heterogeneous Agents, Liquidation Risk, Asset Pricing, Fire-Sales, Noise Traders, Random Dynamical Systems

JEL Classification: G11, G12, C62