Liquidity and Market Crashes

44 Pages Posted: 26 May 2008 Last revised: 17 Apr 2022

See all articles by Jennifer C. Huang

Jennifer C. Huang

University of Texas at Austin - Department of Finance

Jiang Wang

Massachusetts Institute of Technology (MIT) - Sloan School of Management; China Academy of Financial Research (CAFR); National Bureau of Economic Research (NBER)

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Date Written: May 2008

Abstract

In this paper, we develop an equilibrium model for stock market liquidity and its impact on asset prices when constant market presence is costly. We show that even when agents' trading needs are perfectly matched, costly market presence prevents them from synchronizing their trades and hence gives rise to endogenous order imbalances and the need for liquidity. Moreover, the endogenous liquidity need, when it occurs, is characterized by excessive selling of significant magnitudes. Such liquidity-driven selling leads to market crashes in the absence of any aggregate shocks. Finally, we show that illiquidity in the market leads to high expected returns, negative and asymmetric return serial correlation, and a positive relation between trading volume and future returns. We also propose new measures of liquidity based on its asymmetric impact on prices and demonstrate a negative relation between these measures and expected stock returns.

Suggested Citation

Huang, Jennifer Chunyan and Wang, Jiang, Liquidity and Market Crashes (May 2008). NBER Working Paper No. w14013, Available at SSRN: https://ssrn.com/abstract=1137106

Jennifer Chunyan Huang

University of Texas at Austin - Department of Finance ( email )

McCombs School of Business, B6600
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Jiang Wang (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

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