Leaning Against the Wind

To purchase or authenticate to the full-text of this article, please visit this link: http://dx.doi.org/10.1111/j.1467-937X.2007.00451.x Byline: PIERRE-OLIVIER WEILL (a) Abstract: 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. Author Affiliation: (a)University of California, Los Angeles Article History: First version received April 2006; final version accepted January 2007 (Eds.)