2017/33 | LEM Working Paper Series | ||||||||||||||||
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Asset prices and wealth dynamics in a financial market with endogenous liquidation risk |
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Pietro Dindo and Jacopo Staccioli |
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Keywords | |||||||||||||||||
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Heterogeneous Agents, Liquidation Risk, Asset Pricing, Fire-Sales, Noise Traders, Random Dynamical Systems
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JEL Classifications | |||||||||||||||||
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G11, G12, C62
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Abstract | |||||||||||||||||
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Within a financial market where a risk-free bond and a long-lived
risky asset are exchanged by investors with heterogeneous trading
rules, we assume that the investors most exposed to the risky asset
are subject to joint liquidation needs. The latter encompass a risk
whenever the market impact of traders subject to them is large enough,
due to a fire-sale phenomenon. Our aim is to provide conditions for
the transformation of liquidation needs into liquidation risk, and to
characterize the resulting asset price dynamics. We find that when the
average position of traders subject to liquidation needs is lower than
the position of the other traders, the former vanish and asset prices
are driven solely by the dividend process. Whether liquidation risk
becomes systemic or its impact is mitigated by the position of other
traders, depends on the relative wealth dynamics. We provide
conditions on agents positions under which the liquidation risk is
always systemic because the aggressive traders dominate, as well as
conditions under which the size of the liquidation risk is
endogenously determined because all traders survive and the relative
wealth dynamics is a mean reverting process.
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