Journal Article

Leaning Against the Wind

Pierre-Olivier Weill

in The Review of Economic Studies

Published on behalf of Review of Economic Studies Ltd

Volume 74, issue 4, pages 1329-1354
Published in print October 2007 | ISSN: 0034-6527
Published online October 2007 | e-ISSN: 1467-937X | DOI: http://dx.doi.org/10.1111/j.1467-937X.2007.00451.x
Leaning Against the Wind

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During financial disruptions, market makers provide liquidity by absorbing external selling pressure. They buy when the pressure is large, accumulate inventories, and sell when the pressure alleviates. This paper studies optimal dynamic liquidity provision in a theoretical market setting with large and temporary selling pressure and order-execution delays. I show that competitive market makers offer the socially optimal amount of liquidity, provided they have access to sufficient capital. If raising capital is costly, this suggests a policy role for lenient central bank lending during financial disruptions.

Keywords: G14; G24

Journal Article.  12785 words.  Illustrated.

Subjects: Investment Banking ; Economics

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