A Theory of Correlated-Demand Driven Liquidity Commonality

Many empirical studies suggest that correlated demand is important in driving liquidity commonality among stocks. However, there are still no theoretical studies on how demandside factors cause and affect liquidity and return commonality. We propose a tractable equilibrium model with asymmetric information and imperfect competition among market makers to study the effect of correlated demand on the commonality in liquidity, in liquidity risks and in returns. We solve the equilibrium bid and ask prices, bid and ask depths, trading volume, and inventory levels in closed-form. Our model can help explain why liquidity crashes can be caused by non-fundamental news and why market liquidity can be worse and liquidity commonality can be greater in significantly declined markets and in more volatile markets. Our model also generates some new empirically testable implications