How do Extreme Price Movements End?
94 Pages Posted: 14 Nov 2020 Last revised: 24 Dec 2022
Date Written: September 26, 2020
Abstract
We test competing theories of liquidity dynamics during extreme price movements (EPMs). We find that liquidity providers strategically allow for price pressures and are compensated from correcting pricing errors. As a result, liquidity provision intensifies towards the end of a typical EPM. This goes counter to a widespread concern that market making constraints cause liquidity to deteriorate as EPMs develop. The prevailing limit order book dynamics during EPMs are in line with Weill’s (2007) socially beneficial equilibrium.
Keywords: extreme price movements, price pressures, strategic liquidity provision
JEL Classification: G10, G14
Suggested Citation: Suggested Citation