| This dissertation contains three essays that explore financial markets with liquidity frictions. The first chapter theoretically examines the dynamics of collateral liquidations that occur when a hedge fund (or other financial institution) defaults. The dynamics of such liquidations are modeled as a continuous-time trading game, in which balance-sheet constrained lenders unwind illiquid collateral positions. The model predicts that (i) the equilibrium price of the collateral asset overshoots during liquidation when the liquidating lenders are sufficiently balance-sheet constrained; (ii) spreading a collateral position across multiple lenders alleviates balance sheet constraints, but can cause inefficient 'racing to the market', potentially reducing expected liquidation proceeds; (iii) lenders should take into account a hedge fund's creditor structure and their own balance sheet constraints when setting margins to manage counterparty risk; and (iv) shows how to pin down the block price and expected profit at which a 'deep pocket' buyer can purchase the entire collateral position.;The second chapter explores the speed of arbitrage across illiquid markets. The model shows that when arbitrageurs internalize price impact in the markets where they buy and sell, illiquidity frictions result in gradual arbitrage, i.e. mispricings are corrected slowly over time. An increase in illiquidity slows down arbitrage in two ways. First, illiquidity directly affects the equilibrium trading strategies for a given level of competition among arbitrageurs (strategic effect). Second, a rise in illiquidity reduces the number of arbitrageurs that stand ready to trade between the two markets in free-entry equilibrium, further slowing down the speed of arbitrage (competition effect).;The third chapter, joint work with Markus Brunnermeier, examines predatory short selling of equity in financial institutions. We show that when the stock of a leverage-constrained financial institution is shorted aggressively, this can trigger liquidations of long-term investments at fire-sale prices. Predatory short selling can emerge in equilibrium when a financial institution is (i) close to its leverage constraint (the vulnerability region) or (ii) violates its leverage constraint even in the absence of short selling (the constrained region). The model provides a potential justification for temporary restrictions on short selling for vulnerable institutions. |
