Mutual Fund Fire-sales Externalities and Liquidity Management: Mechanisms,Consequences and Policy Effects

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Journal of Central University of Finance & Economics ›› 2022, Vol. 0 ›› Issue (8) : 25-42.

WANG Hui, NING Wei

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Abstract

In this paper,we construct a multi-period theoretical framework,which incorporates the characteristics such as high-frequency low-loss redemptions,liquidity mismatch,and size incentive of mutual fund manager,to analyze the risk contagion and the related liquidity management.The results show that,firstly,the liquidity mismatch caused by mutual funds' net asset value calculation rules makes the remaining fund investors bear the liquidation costs of initial investor redemptions,amplifying fire-sale's negative impact on risky asset prices and the ratchet effect between investor redemptions and asset fire-sales.Secondly,compared with the single-period benchmark model,the multi-period model constructed in this paper can more accurately characterize the fire-sale risk,and the optimal liquidity reserve determined in this paper can effectively reduce the negative externality of fire-sale on affiliated funds.Thirdly,with the incentive of maximizing the size of assets under management,mutual funds do have an incentive to hold additional liquidity reserves to reduce the externality cost of fire-sale on affiliated funds.Moreover,for the parameters sensitivity,optimal liquidity reserve shows a positive relationship with the state of the market and a negative relationship with the level of market illiquidity,the sensitivity of investors to a market decline and the similarity of asset holding with affiliated funds.Furthermore,this paper evaluates the policy effects of large redemption restriction.We find that the large redemption restriction alleviates the fund's initial fire-sale pressure,reduces the liquidation costs borne by the remaining investors,eases the fund' s liquidity constraint,and can significantly reduce the fire-sale impact on risky assets prices.

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Investor redemption / Mutual fund fire-sales / Ratchet effect / Liquidity management / Large redemption restriction

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WANG Hui, NING Wei. Mutual Fund Fire-sales Externalities and Liquidity Management: Mechanisms,Consequences and Policy Effects[J]. Journal of Central University of Finance & Economics, 2022, 0(8): 25-42

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