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Liquidity Risk and the Dynamics of Arbitrage Capital

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  • Kondor, Péter
  • Vayanos, Dimitri

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.

Suggested Citation

  • Kondor, Péter & Vayanos, Dimitri, 2014. "Liquidity Risk and the Dynamics of Arbitrage Capital," CEPR Discussion Papers 9885, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:9885
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    Cited by:

    1. Denis Gromb & Dimitri Vayanos, 2015. "The Dynamics of Financially Constrained Arbitrage," NBER Working Papers 20968, National Bureau of Economic Research, Inc.
    2. Ralph S.J. Koijen & Motohiro Yogo, 2015. "An Equilibrium Model of Institutional Demand and Asset Prices," NBER Working Papers 21749, National Bureau of Economic Research, Inc.
    3. Dimitri Vayanos & Peter Kondor, 2014. "Liquidity Risk and the Dynamics of Arbitrage Capital," 2014 Meeting Papers 912, Society for Economic Dynamics.
    4. Nina Karnaukh & Angelo Ranaldo & Paul Söderlind, 2015. "Understanding FX Liquidity," Review of Financial Studies, Society for Financial Studies, vol. 28(11), pages 3073-3108.
    5. Andrea L. Eisfeldt & Hanno Lustig & Lei Zhang, 2017. "Complex Asset Markets," NBER Working Papers 23476, National Bureau of Economic Research, Inc.
    6. Isaenko, Sergey, 2015. "Equilibrium theory of stock market crashes," Journal of Economic Dynamics and Control, Elsevier, vol. 60(C), pages 73-94.

    More about this item

    Keywords

    Arbitrage capital; Asset pricing; Liquidity; Liquidity risk; Risk-sharing;

    JEL classification:

    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • G01 - Financial Economics - - General - - - Financial Crises
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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