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Episodic Liquidity Crises: Cooperative and Predatory Trading

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  • BRUCE IAN CARLIN
  • MIGUEL SOUSA LOBO
  • S. VISWANATHAN

Abstract

We describe how episodic illiquidity arises from a breakdown in cooperation between market participants. We first solve a one‐period trading game in continuous‐time, using an asset pricing equation that accounts for the price impact of trading. Then, in a multi‐period framework, we describe an equilibrium in which traders cooperate most of the time through repeated interaction, providing apparent liquidity to one another. Cooperation breaks down when the stakes are high, leading to predatory trading and episodic illiquidity. Equilibrium strategies that involve cooperation across markets lead to less frequent episodic illiquidity, but cause contagion when cooperation breaks down.

Suggested Citation

  • Bruce Ian Carlin & Miguel Sousa Lobo & S. Viswanathan, 2007. "Episodic Liquidity Crises: Cooperative and Predatory Trading," Journal of Finance, American Finance Association, vol. 62(5), pages 2235-2274, October.
    • Handle: RePEc:bla:jfinan:v:62:y:2007:i:5:p:2235-2274
    DOI: 10.1111/j.1540-6261.2007.01274.x
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