Systemic Liquidation Risk and the Diversity–Diversification Trade-Off



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    • Wagner is at the European Banking Centre, TILEC, CentER, and Department of Economics, Tilburg University. I thank the Editor (Campbell R. Harvey), an associate editor, an anonymous referee, participants at seminars at the Bank of England, the Bank for International Settlements, Bangor Business School, Cass Business School, the CPB, Frankfurt University, University of Groningen, ISCTE Lisbon, University of Porto, Tilburg University, University of Illinois at Urbana-Champaign, and conference participants at the AFA 2010, the CEPR Summer Symposium Gerzensee 2009, the FIRS 2010 Conference, the Chulalongkorn Accounting and Finance Symposium 2009, the EFA 2009, the MTS-LSE Conference on Financial Markets 2009, the Skinance 2009 Conference, the Conference on Liquidity and Pricing in Konstanz 2009, and the Austrian National Bank Conference on Financial Fragility for comments. I also thank John Boyd, Falko Fecht (discussant), Thierry Foucault (discussant), Hans Gersbach, Pab Jotikasthira (discussant), Ron Kaniel (discussant), Nobuhiro Kyotaki, Jun Liu (discussant), John Moore, Axel Adam-Müller (discussant), Alexander Stomper (discussant), Harald Uhlig, and Tanju Yorulmazer (discussant) for comments. I especially thank Javier Suarez for discussions on this project. An earlier version of the paper was circulated under the title “The Risk of Joint Liquidation and Portfolio Choice: Diversity Instead of Diversification.”


This paper proposes a portfolio choice model in which investors are subject to liquidation risk and (endogenously) face higher costs in the event of joint liquidation (as was observed during the crisis of 2008 to 2009). The risk of joint liquidation creates an incentive for investors to choose heterogeneous portfolios and to rationally forgo diversification benefits. Joint liquidation risk is also reflected in asset prices, resulting in (1) assets with high idiosyncratic risk having low expected returns, and (2) assets that display high correlation with the portfolios of (liquidation-prone) investors having high expected returns.