Comparing financial market exit with cinema hall exit

Lasse H. Pedersen of NYU received the 2011 Bernacer Prize (modeled on Clark medal and given to happening European econs below 40; though most of the winners work in US univs). Here is a nice speech from Vítor Constâncio, Vice-President of ECB explaining his research.

I was scanning his research (high quant stuff in finance) and came across this fab paper. It compares exits in financial markets with those in cinema halls:

The dangers of shouting “fire” in a crowded theater are well understood, but the dangers of rushing to the exit in the financial markets are more complex. Yet, the two events share several features, and I analyze why people crowd into theaters and trades, why they run, what determines the risk, whether to return to the theater or trade when the dust settles, and how much to pay for assets (or tickets) in light of this risk. These theoretical considerations shed light on the recent global liquidity crisis and, in particular, the quant event of 2007.

He says we have similar objectives in finance and in cinema halls. Even exits are similar:

People choose to crowd into a theater or a trade because they share a common goal: in one case, they all want to see the best play in town; in the other, they all pursue the highest risk-adjusted return. They run for the exit because staying is associated with real risk, namely being caught in the theater fire or being forced to liquidate at the most distressed prices. Many people running introduces a second, and endogenous, risk: theater guests risk being trampled by running feet, and traders risk being trampled by falling prices, margin calls, and vanishing capital—a negative externality that increases the aggregate risk.

The risk of running for the exit depends on how crowded the theater or trade is, and the quality of risk management. The  liquidity risk can be reduced by restricting reliance on funding that cannot be depended on during crises, by limiting how large and levered positions one takes, or, even better, if the leveraged players limit how large an aggregate position they take relative to their capital.

Finally, investors return to these markets as liquidity crises create opportunities. Indeed, the expected return on liquidity provision rises during crisis. Just like fear of a theater fire would reduce ticket prices, liquidity risk reduces asset prices

The focus is on the crisis which started in 2007. He goes on to show the importance of liquidity in financial markets.

I focus on the “quant” event of August 2007 as it illustrates well the nature of liquidity crises. While this event was almost  invisible to the public, it can be seen very clearly through the lens of a diversified long-short strategy. Quantitative traders running for the exit had a significant impact on some of the most liquid markets in the world, and I show how prices dropped and rebounded in early August 2007. Using high-frequency data, I document an amazing short-term predictability and volatility driven by the run to the exit (figure 1, panel A). In hindsight, the quant crisis was an early warning signal of how the levered system would face trouble as the liquidity spirals caused havoc in the global markets.

There is a graph on page 4 of the paper which compares the liquidity exit in a quant fund vs. model predicted path. There is amazing similarity.

He revamps CAPM to liquidity CAPM (see this paper) where  investors are provided returns for liquidity risk as well.

Investors need to manage both their funding liquidity risk— including their cash management, the financing terms (margins/ haircuts), and the risk of change s in financing or equity redemptions—and their market liquidity risk, including the trading costs, possible hikes in trading costs, the time it takes to  unwind positions in an orderly fashion, and the risk of predatory trading (Brunnermeier and Pedersen 2005, 2009). 

Further, investors need to be compensated for taking liquidity risk. Their pricing models should capture market liquidity risk (Acharya and Pedersen 2005) and funding liquidity risk (Garleanu and Pedersen 2009).

Some investors can make gains when liquidity crisis eases as markets make a comeback:

While predicting liquidity crises in advance is very challenging, it is useful to understand whether price drops that already occurred were due to liquidity or fundamentals. This is because liquidity events present both risks and opportunities—liquidity-induced price drops tend to revert, and investors with dry powder can try to capture this rebound.

During a liquidity crisis, central banks can use unconventional monetary tools that improve the financing environment—
e.g., by offering collateralized loans at lower (but still prudent) haircuts/margins—and, in good times, central banks need to reduce banks’ incentive to take on systemic risk (Acharya et al. 2009, Ashcraft, Gˆarleanu, and Pedersen 2009, C´urdia and Woodford 2009, Gertler and Karadi 2009, and Reis 2009).

Very useful analogy to cinema hall exits.

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