Working Paper: NBER ID: w14119
Authors: Ricardo Lagos; Guillaume Rocheteau; Pierre-Olivier Weill
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: Liquidity; Market Crashes; Dealers; Asset Markets; Financial Stability
JEL Codes: C78; D83; E44; G1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| temporary negative shock to investors' aggregate asset demand (G19) | dynamics of liquidity provision by dealers during a market crash (E44) |
| market fundamentals (G10) | dealers' liquidity provision (E44) |
| severity and persistence of the market crash (G01) | dealers' willingness to provide liquidity (E41) |
| trading frictions are small (F12) | investors absorb selling pressure (G19) |
| trading frictions are large (F12) | dealers do not find it profitable to accumulate inventories (L81) |
| anticipated capital gains (G11) | dealers' incentives to provide liquidity (G24) |
| bargaining strength (C79) | dealers' willingness to accumulate inventories (L81) |