Learning from prices, liquidity spillovers, and market segmentation

This working paper looks at causes for the occurrence of liquidity (or illiquidity) spillovers across markets and proposes a novel theoretical explanation that provides interesting insights into recent events, for example the 'Flash Crash' of May 2010.

Dealers use prices of other securities as a source of information. As prices of less liquid securities convey less precise information, a drop in liquidity for one security raises the uncertainty for dealers in other securities, thereby affecting their liquidity.

The direction of liquidity spillovers is positive if the fraction of dealers with price information on other securities is high enough. Otherwise liquidity spillovers can be negative. A new mechanism is described that explains the transmission of liquidity shocks from one security to another ('liquidity spillovers').

This article forms part of a wider research project in which the research team will look at the behaviour of liquidity in financial markets.

The full working paper is now available for you to download below. Let us know what you think in the comments box.

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