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Liquidity and Risk Management

Nicolae B. Garleanu and Lasse Pedersen

No 12887, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: This paper provides a model of the interaction between risk-management practices and market liquidity. On one hand, tighter risk management reduces the maximum position an institution can take, thus the amount of liquidity it can offer to the market. On the other hand, risk managers can take into account that lower liquidity amplifies the effective risk of a position by lengthening the time it takes to sell it. The main result of the paper is that a feedback effect can arise: tighter risk management reduces liquidity, which in turn leads to tighter risk management, etc. This can help explain sudden drops in liquidity and, since liquidity is priced, in prices in connection with increased volatility or decreased risk-bearing capacity.

JEL-codes: G10 (search for similar items in EconPapers)
Date: 2007-02
New Economics Papers: this item is included in nep-cfn, nep-fmk and nep-rmg
Note: AP
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Published as Nicolae Gârleanu & Lasse Heje Pedersen, 2007. "Liquidity and Risk Management," American Economic Review, American Economic Association, vol. 97(2), pages 193-197, May.

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