Liquidity Shocks and Stock Bubbles

This study presents and empirically tests a simple framework that examines the effects of asset liquidity (the ease with which stocks are traded) and funding liquidity (the ease with which market participants can obtain funding) shocks on stock bubbles. Three key findings emerge from this research. First, negative liquidity shocks increase the probability of stock bubbles collapsing, with shocks to funding liquidity having a more prevalent effect on bubbles than asset liquidity shocks. Second, the effects of these two genres of liquidity shocks on bubbles have become more significant after the subprime mortgage meltdown-induced crisis. Last, liquidity shocks can provide warning signals of an impending bubble collapse.