Working Paper Series no. 179: Forced Portfolio Liquidation

Abstract

We study the problem of a leveraged investor that is forced to unwind a significant fraction of its portfolio in a collection of illiquid markets. It is shown that markets may become disrupted in response to a relatively small liquidity shock. As a consequence, the probability of default can be much higher than suggested by standard risk measures. We also study the impact of successful liquidation on relative asset prices. Our analysis suggests that effective risk management of leveraged financial entities should focus on the entity's potential to generate emergency cash-flows net of third-party claims for liquidity.

Christian Ewerhart and Natacha Valla
September 2007

Classification JEL : G11, E58.

Keywords : Portfolio liquidation, market disruption, leverage, determinants of asset liquidity, hedge funds, structured credit.