Liquidity risk and the dynamics of arbitrage capital

Kondor, Peter ORCID: 0000-0001-9797-9291 and Vayanos, Dimitri ORCID: 0000-0002-0944-4914 (2019) Liquidity risk and the dynamics of arbitrage capital. Journal of Finance, 74 (3). pp. 1139-1173. ISSN 0022-1082

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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.

Item Type:	Article
Official URL:	https://onlinelibrary.wiley.com/journal/15406261
Additional Information:	© 2019 American Finance Association
Divisions:	Finance
Subjects:	H Social Sciences > HG Finance
Date Deposited:	18 Apr 2018 11:12
Last Modified:	09 Nov 2024 23:00
Projects:	336585
Funders:	European Research Council, Paul Woolley Centre
URI:	http://eprints.lse.ac.uk/id/eprint/87520

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