A Run On A Financial Market∗

Our paper offers a minimalist model of a run on a financial market. The prime ingredient is that each investor fears having to liquidate after a run, but before prices can recover back to fundamental values. During the run, only the market-making sector is willing to absorb shares. To avoid having to possibly liquidate shares at the marginal post-run price—in which case the market-making sector will already hold a lot of share inventory and thus be more reluctant to absorb additional shares—all investors may prefer selling their shares into the market today at the average run price, thereby causing the run itself. Liquidity runs and crises are not caused by liquidity shocks per se, but by the fear of future liquidity shocks. ∗This is a preliminary version. Please do not circulate. The most recent version of this paper will be available from http://welch.som.yale.edu/academics/. We thank Harry Mamaysky for useful conversations.