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Market Liquidity and Funding Liquidity

29 Pages Posted: 22 Mar 2005  

Lasse Heje Pedersen

AQR Capital Management, LLC; Copenhagen Business School - Department of Finance; New York University (NYU); Centre for Economic Policy Research (CEPR)

Markus K. Brunnermeier

Princeton University - Department of Economics

Date Written: March 2005

Abstract

We provide a model that links a security's market liquidity --- i.e., the ease of trading it --- and traders' funding liquidity --- i.e., their availability of funds. Traders provide market liquidity and their ability to do so depends on their funding, that is, their capital and the margins charged by their financiers. In times of crisis, reductions in market liquidity and funding liquidity are mutually reinforcing, leading to a liquidity spiral. The model provides a natural explanation for the empirically documented features that market liquidity: (i) periodically dries up, (ii) has commonality across securities, (iii) is related to volatility, (iv) experiences flight to liquidity events, and (v) comoves with the market. Finally, the model shows how the Fed can improve current market liquidity by committing to improve funding in a potential future crisis.

Keywords: Liquidity, risk management, systemic risk, haircuts, margins

JEL Classification: G1, G2

Suggested Citation

Pedersen, Lasse Heje and Brunnermeier, Markus K., Market Liquidity and Funding Liquidity (March 2005). AFA 2006 Boston Meetings Paper. Available at SSRN: https://ssrn.com/abstract=688065 or http://dx.doi.org/10.2139/ssrn.688065

Lasse Heje Pedersen

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

Copenhagen Business School - Department of Finance ( email )

Solbjerg Plads 3
Frederiksberg, DK-2000
Denmark

New York University (NYU) ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

Centre for Economic Policy Research (CEPR) ( email )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Markus Konrad Brunnermeier (Contact Author)

Princeton University - Department of Economics ( email )

Bendheim Center for Finance
Princeton, NJ
United States
609-258-4050 (Phone)
609-258-0771 (Fax)

HOME PAGE: http://www.princeton.edu/¡­markus

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