Working Paper: NBER ID: w9251
Authors: Antonio E. Bernardo; Ivo Welch
Abstract: Our paper offers a minimalist model of a run on a financial market. The prime ingredient is that each risk-neutral investor fears having to liquidate after a run, but before prices can recover back to fundamental values. During the urn, only the risk-averse market-making sector is willing to absorb shares. To avoid having to possibly liquidate shares at the marginal post-run price in which case the market-making sector will already hold a lot of share inventory and thus be more reluctant to absorb additional shares all investors may prefer selling their shares into the market today at the average run price, thereby causing the run itself. Consequently, stock prices are low and risk is allocated inefficiently. Liquidity runs and crises are not caused by liquidity shocks per se, but by the fear of future liquidity shocks.
Keywords: No keywords provided
JEL Codes: G2; G1; G21; E44; N2
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| fear of liquidity shocks (E44) | inefficient selling behavior (D22) |
| inefficient selling behavior (D22) | stock prices drop (G10) |
| fear of liquidity shocks (E44) | market runs (D40) |
| fear of liquidity shocks (E44) | low stock prices (G10) |
| fear of liquidity shocks (E44) | inefficient risk allocation (D61) |
| investor fear (G41) | market runs (D40) |
| investor fear (G41) | low stock prices (G10) |
| investor fear (G41) | inefficient risk allocation (D61) |