Crashes and recoveries in illiquid markets

Lagos, Ricardo; Rocheteau, Guillaume; Weill, Pierre-Olivier

doi:10.26509/frbc-wp-200708

Working Paper

Crashes and recoveries in illiquid markets

Abstract: We study the dynamics of liquidity provision by dealers during an asset market crash, described as a temporary negative shock to investors? aggregate asset demand. We consider a class of dynamic market settings where dealers can trade continuously with each other, while trading between dealers and investors is subject to delays and involves bargaining. We derive conditions on fundamentals, such as preferences, market structure and the characteristics of the market crash (e.g., severity, persistence) under which dealers provide liquidity to investors following the crash. We also characterize the conditions under which dealers? incentives to provide liquidity are consistent with market efficiency.

Keywords: Asset pricing; Portfolio management; Financial crises; Liquidity (Economics);

https://doi.org/10.26509/frbc-wp-200708