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Federal Reserve Bank of Cleveland
Working Papers (Old Series)
Crashes and recoveries in illiquid markets
Ricardo Lagos
Guillaume Rocheteau
Pierre-Olivier Weill

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.

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Ricardo Lagos & Guillaume Rocheteau & Pierre-Olivier Weill, Crashes and recoveries in illiquid markets, Federal Reserve Bank of Cleveland, Working Papers (Old Series) 0708, 2007.
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Keywords: Asset pricing ; Portfolio management ; Financial crises ; Liquidity (Economics)
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