There has been a surge in the recent academic literature on issues concerning liquidity (starting with Amihud and Mendelson, 1986) and liquidity risk (Pastor and Stambaugh, 2003, and Acharya and Pedersen, 2005). While practitioners would perhaps question the relatively late arrival of these topics into academic focus, academics have traditionally preferred to look at the world through the lens of complete, or at least frictionless markets. The limitations of this traditional approach have however become glaringly transparent over the last decade or two in the wake of major financial events in which the ability to trade securities and access capital-market financing declined substantially.

The most striking of these events include the stock market crash of 1987 in the United States, the Russian default in 1998, the Long Term Capital Management episode that followed, and, most recently, the aftermath of GM and Ford downgrade. It is thus timely and fitting to examine what we can learn from these events about sources of (il)liquidity and liquidity risk, and their implications for risk management at banks and financial institutions. As a part of this investigation, we will also look at the relation between the developing theory on liquidity risk and the apparently separate literature on correlation risk the fluctuations over time in the correlation of returns across securities.