What Happens To Financial Markets When Everyone Runs for the Exit ?

Abstract (Via NYU)

The dangers of shouting re” in a crowded theater are well understood, but the dangers of rushing to the exit in the financial markets are more complex.Yet, the two events share several features, and I analyze why people crowd into theaters and trades, why they run, what determines the risk, whether to return to the theater or trade when the dust settles, and how much to pay for assets (or tickets) in light of this risk. These theoretical considerations shed light on the recent global liquidity crisis and, in particular, the quant event of 2007.

Introduction (Via NYU)

People choose to crowd into a theater or a trade because they share a common goal: in one case, they all want to see the best play in town, in the other, they all pursue the highest risk-adjusted return. They run for the exit because staying is associated with real risk, namely being caught in the theater re or being forced to liquidate at the most distressed prices. Many people running introduces a second, and endogenous, risk: Theater guests risk being trampled by running feet, and traders risk being trampled by falling prices, margin calls, and vanishing capital a negative externality that increases the aggregate risk.

The risk of running for the exit depends on how crowded the theater or trade is, and the quality of risk management. The liquidity risk can be reduced by restricting reliance on funding that cannot be depended on during crises, by limiting how large and levered positions one takes, or, even better, if the leveraged players limit how large an aggregate position they take relative to their capital. Finally, investors return to these markets as liquidity crises create opportunities. Indeed, the expected return on liquidity provision rises during crisis. Just like fear of a theater re would reduce ticket prices, liquidity risk reduces asset prices.

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12. August 2009 by Miguel Barbosa
Categories: Curated Readings, Finance & Investing | Leave a comment

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