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Liquidity risk and the dynamics of arbitrage capital

Author

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  • Kondor, Peter
  • Vayanos, Dimitri
Abstract
We develop a continuous-time model of liquidity provision in which hedgers can trade multiple risky assets with arbitrageurs. Arbitrageurs have constant relative risk-aversion (CRRA) utility, while hedgers' asset demand is independent of wealth. An increase in hedgers' risk aversion can make arbitrageurs endogenously more risk-averse. Because arbitrageurs generate endogenous risk, an increase in their wealth or a reduction in their CRRA coefficient can raise risk premia despite Sharpe ratios declining. Arbitrageur wealth is a priced risk factor because assets held by arbitrageurs offer high expected returns but suffer the most when wealth drops. Aggregate illiquidity, which declines in wealth, captures that factor.

Suggested Citation

  • Kondor, Peter & Vayanos, Dimitri, 2019. "Liquidity risk and the dynamics of arbitrage capital," LSE Research Online Documents on Economics 87520, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:87520
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    More about this item

    Keywords

    liquidity risk; wealth effects; heterogeneous agents; intermediary asset pricing; endogenous risk;
    All these keywords.

    JEL classification:

    • F3 - International Economics - - International Finance
    • G3 - Financial Economics - - Corporate Finance and Governance

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    This paper has been announced in the following NEP Reports:

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