Friday, March 26, 2010

Liquidity Risk, Derivatives and Arrow-Debreu Securities

By Jianbo Tian

Abstract: Instead to explain liquidity risk by the dramatically price fall during crisis, this paper build up a model to understand liquidity risk by bank's daily operation to match deposit uncertainty and loan demand uncertainty. The findings are: liquidity risk distinguished itself from credit risk by its own characteristics, which exists all the time and may trigger a crisis under the credit-risk-free environment; banks take derivatives as Arrow-Debreu securities to share and eliminate liquidity risk; more important, the limit of derivatives market is set up by the size of idiosyncratic liquidity risk. When banks and other financial institutions have an erroneously assumption that the derivative market is unlimited deep and overload the market, banking industry loses its capability to absorb any negative economic shock, and a small shock may trigger a crisis.

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