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Risky Arbitrage and Collateral Policies

Author

Listed:
  • Ally Zhang

    (University of Zurich and Swiss Finance Institute)

Abstract

We construct a dynamic model economy in which investors from segmented markets have varying financial asset demands. Intermediaries make arbitrage profits by exploiting the price spreads across markets. Meanwhile, they are required to separately post collateral to support arbitrage trades. We show that with volatile asset demands, arbitrage becomes risky. With information frictions, a looser collateral policy might render the economy more vulnerable to extremely large demand shocks, while a tighter collateral constraint helps maintain the stability at the cost of market liquidity supply.

Suggested Citation

  • Ally Zhang, 2017. "Risky Arbitrage and Collateral Policies," Swiss Finance Institute Research Paper Series 17-56, Swiss Finance Institute.
    • Handle: RePEc:chf:rpseri:rp1756
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    More about this item

    Keywords

    collateral; financial constraints; systemic risk; liquidity; financial stability; incomplete markets;
    All these keywords.

    JEL classification:

    • C68 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computable General Equilibrium Models

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