Market Crashes, Correlated Illiquidity, and Portfolio Choice

Market Crashes, Correlated Illiquidity, and Portfolio Choice

T recent financial crisis highlights the importance of market crashes and the subsequent market illiquidity for optimal portfolio selection. We propose a tractable and flexible portfolio choice model where market crashes can trigger switching into another regime with a different investment opportunity set. We characterize the optimal trading strategy in terms of coupled integro-differential equ...

Market Crashes , Correlated Illiquidity , and “ Flight to Quality ” ∗

Models with i.i.d. returns and perfect liquidity (e.g., Merton (1971)) suggest that after a stock price crash, investors should buy more stock. However, many investors sell stock to buy safe assets after a market crash (a “flight-to-quality”), even when market liquidity has significantly worsened. In this paper, we propose a tractable and flexible portfolio selection model where market crashes ...

Illiquidity Contagion and Liquidity Crashes∗

Liquidity providers in a security often use prices of other securities as a source of information to set their quotes. As a result, liquidity is higher when prices are more informative. In turn, prices are more informative when liquidity is higher. We show that this self-reinforcing relationship between price informativeness and liquidity is a source of contagion and fragility: a small drop in ...

Illiquidity, Portfolio Constraints, and Diversification *

Hedging, stock market participation and portfolio choice∗

We exploit the restrictions of intertemporal portfolio choice in the presence of nonfinancial income risk to design and implement tests of hedging that use the information contained in the actual portfolio of the investor. We use a unique dataset of Swedish investors with information broken down at the investor level and into various components of wealth, investor income, tax positions and inve...