Ebook The Risk of Joint Liquidation and Portfolio Choice: Diversity instead of Diversification!
Investors often have to liquidate following a drop in the value of their portfolios. Since in such situations many investors are typically liquidating at the same time, asset prices are likely to be depressed. For example, several asset-backed securities are currently trading at fire-sale prices because investors were forced to sell them after a decline in their value eroded capital (banks), caused withdrawals (hedge funds), made collateral constraints binding (again hedge funds) or triggered margin calls (traders).
Similarly, the current distress in the housing market is a result of liquidations initiated by a drop in house prices which made many highly mortgaged households essentially insolvent. Another example is the 1987 stock market crash, which has been (at least partly) attributed to automatic trading by institutional investors which stipulated the selling of assets after they had fallen by a certain amount.
The main idea of this paper is that rational investors should take into account the risk of such joint liquidations when making their investment decisions. I show that there are important implications for optimal portfolio allocations, as well as for asset prices. I consider a simple two-asset economy in which investors have to liquidate their portfolio if its value falls below a threshold (this may be, for example, a solvency or a collateral constraint). If an investor’s cost of liquidation (arising because he may only be able to sell at low prices) were constant, the standard result obtains that investors diversify fully in order to minimize the risk of liquidation.
However, when the liquidation costs are increasing in the number of investors liquidating at the same time, this is no longer the case. The reason is simple. If all investors diversify fully, they hold identical portfolios. This implies that if one investor’s portfolio value falls below the threshold, the other investors’ portfolios value are doing so as well. Investors will hence tend to liquidate together, which would cause large liquidation losses. As a consequence of this, investors optimally forego diversification benefits in order to avoid being pooled together in a liquidation. By the same reasoning it is also not optimal for a large amount of investors to hold any given portfolio at the same time. Rather, in order to minimize the risk of liquidation with other investors, investors want to hold diverse portfolios in order to be different from each other.
Download
PDF Ebook The Risk of Joint Liquidation and Portfolio Choice: Diversity instead of Diversification!
Posted in :
