Stochastic Analysis Common
TITLE: Can Swing Pricing Prevent Mutual Fund Runs and Fire Sales?
ABSTRACT: We develop a model of the feedback between mutual fund outflows and asset illiquidity. Alert investors anticipate the impact on the fund's net asset value of other investors' redemptions and exit first at favorable prices. This first-mover advantage may lead to fund failure through a cycle of falling prices and increasing redemptions.
Our analysis shows that (i) the first-mover advantage introduces a nonlinear dependence between an exogenous market shock and the aggregate impact of redemptions on the asset price; (ii) as a consequence, there is a critical magnitude of the shock beyond which a run brings down the fund; (iii) properly designed swing pricing transfers liquidation costs from the fund to redeeming investors and, by removing the nonlinearity stemming from the first-mover advantage, it reduces these costs and prevents fund failure.TBD