Liquidity risk and the dynamics of arbitrage capital

Péter Kondor and Dimitri Vayanos

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

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.

JEL-codes: G10 (search for similar items in EconPapers)
Pages: 65 pages
Date: 2014-02-01
New Economics Papers: this item is included in nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (12)

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http://eprints.lse.ac.uk/55910/ Open access version. (application/pdf)

Related works:
Journal Article: Liquidity Risk and the Dynamics of Arbitrage Capital (2019)
Working Paper: Liquidity risk and the dynamics of arbitrage capital (2019)
Working Paper: Liquidity Risk and the Dynamics of Arbitrage Capital (2014)
Working Paper: Liquidity Risk and the Dynamics of Arbitrage Capital (2014)
Working Paper: Liquidity Risk and the Dynamics of Arbitrage Capital (2014)
Working Paper: Liquidity Risk and the Dynamics of Arbitrage Capital (2014)
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