Liquidity and Market Crashes

In this paper, we develop an equilibrium model for stock market liquidity and its impact on asset prices when participation in the market is costly. We show that, even when agents’ trading needs are perfectly matched, costly participation prevents them from synchronizing their trades, which gives rise to the endogenous need for liquidity. Moreover, the endogenous liquidity need, when it occurs, is one-sided and of significant magnitude. In particular, it is dominated by excessive selling which leads to market crashes in the absence of any aggregate shocks. As a result, endogenous liquidity needs gives rise to negative skewness and fat-tails in stock returns. ∗Huang is from McCombs School of Business, B6600, University of Texas at Austin, Austin, TX 78712 (email: [email protected] and tel: (512)232-9375) and Wang is from MIT Sloan School of Management, E52-456, 50 Memorial Drive, Cambridge, MA 02142-1347, CCFR and NBER (email: [email protected] and tel: (617)253-2632). Part of this work was done during Wang’s visit at the Federal Reserve Bank of New York. The authors thank Tobias Adrian, Nobu Kiyotaki, Pete Kyle, Lasse Pedersen, Jacob Sagi, and participants at the Adam Smith Asset Pricing Conference, 2005 Duke-UNC Asset Pricing Conference, 2005 Utah Winter Finance Conference and seminars at Baruch College, Columbia, HEC, HKUST, INSEAD, New York Federal Reserve Bank, University of Michigan, and UT-Austin for comments and suggestions.