Liquidity risk and the dynamics of arbitrage capital

Kondor, Peter ORCID: 0000-0001-9797-9291 and Vayanos, Dimitri ORCID: 0000-0002-0944-4914 (2014) Liquidity risk and the dynamics of arbitrage capital. Financial Markets Group Discussion Papers (730). London School of Economics and Political Science, London, UK.

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Abstract

We develop a dynamic model of liquidity provision, in which hedgers can trade multiple risky assets with arbitrageurs. We compute the equilibrium in closed form when arbitrageurs’ utility over consumption is logarithmic or risk-neutral with a non-negativity constraint. Liquidity is increasing in arbitrageur wealth, while asset volatilities, correlations, and expected returns are hump-shaped. Liquidity is a priced risk factor: assets that suffer the most when liquidity decreases, e.g., those with volatile cashflows or in high supply by hedgers, offer the highest expected returns. When hedging needs are strong, arbitrageurs can choose to provide less liquidity even though liquidity provision is more profitable.

Item Type:	Monograph (Discussion Paper)
Official URL:	https://www.fmg.ac.uk/
Additional Information:	© 2014 The Authors
Divisions:	Finance
Subjects:	H Social Sciences > HG Finance
JEL classification:	G - Financial Economics > G1 - General Financial Markets > G10 - General
Date Deposited:	28 Feb 2014 10:04
Last Modified:	11 Dec 2024 19:13
URI:	http://eprints.lse.ac.uk/id/eprint/55910

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