Liquidity and Market Crashes

43 Pages Posted: 24 Aug 2006 Last revised: 11 Sep 2009

See all articles by Jennifer C. Huang

Jennifer C. Huang

University of Texas at Austin - Department of Finance

Jiang Wang

Massachusetts Institute of Technology (MIT) - Sloan School of Management; China Academy of Financial Research (CAFR); National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: December 2007

Abstract

In this paper, we develop an equilibrium model for stock market liquidity and its impact on asset prices when constant market presence is costly. We show that even when agents' trading needs are perfectly matched, costly market presence prevents them from synchronizing their trades and hence gives rise to endogenous order imbalances and the need for liquidity. Moreover, the endogenous liquidity need, when it occurs, is characterized by excessive selling of significant magnitudes. Such liquidity-driven selling leads to market crashes in the absence of any aggregate shocks. Finally, we show that illiquidity in the market leads to high expected returns, negative and asymmetric return serial correlation, and a positive relation between trading volume and future returns. We also propose new measures of liquidity based on its asymmetric impact on prices and demonstrate a negative relation between these measures and expected stock returns.

Keywords: liquidity, asset prices, crash

JEL Classification: G12

Suggested Citation

Huang, Jennifer Chunyan and Wang, Jiang, Liquidity and Market Crashes (December 2007). Available at SSRN: https://ssrn.com/abstract=925888 or http://dx.doi.org/10.2139/ssrn.925888

Jennifer Chunyan Huang (Contact Author)

University of Texas at Austin - Department of Finance ( email )

McCombs School of Business, B6600
Austin, TX 78712
United States
512-232-9375 (Phone)
512-471-5073 (Fax)

Jiang Wang

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

E62-614
100 Main Street
Cambridge, MA 02142
United States
617-253-2632 (Phone)
617-258-6855 (Fax)

China Academy of Financial Research (CAFR)

1954 Huashan Road
Shanghai P.R.China, 200030
China

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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