Abstract
We study the problem of a leveraged investor that is forced to unwind a significant fraction of its portfolio in a collection of illiquid markets. It is shown that markets may become disrupted in response to a relatively small liquidity shock. As a consequence, the probability of default can be much higher than suggested by standard risk measures. We also study the impact of successful liquidation on relative asset prices. Our analysis suggests that effective risk management of leveraged financial entities should focus on the entity's potential to generate emergency cash-flows net of third-party claims for liquidity.
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