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Liquidity risk and the dynamics of arbitrage capital

Kondor, Peter and Vayanos, Dimitri (2019) Liquidity risk and the dynamics of arbitrage capital. Journal of Finance, 74 (3). pp. 1139-1173. ISSN 0022-1082

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Identification Number: 10.1111/jofi.12757

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
Sets: Departments > Finance
Date Deposited: 18 Apr 2018 11:12
Last Modified: 21 Jan 2020 00:00
Projects: 336585
Funders: European Research Council, Paul Woolley Centre
URI: http://eprints.lse.ac.uk/id/eprint/87520

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