Market run-ups, market freezes, inventories, and leverage

This paper is superseded by Working Paper No. 13-14.> We study trade between a buyer and a seller who have existing inventories of assets similar to those being traded. We analyze how these inventories affect trade, information dissemination, and prices. We show that when traders’ initial leverages are moderate, inventories increase price and trade volume (a market “run-up”), but when leverages are high, trade is impossible (a market “freeze”). Our analysis predicts a pattern of trade in which prices and volumes first increase, and then markets break down. Moreover, the presence of competing buyers may amplify the increased-price effect. We discuss implications for regulatory intervention in illiquid markets.