Liquidity Risk and the Dynamics of Arbitrage Capital

Péter Kondor and Dimitri Vayanos

No 19931, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We develop a continuous-time model of liquidity provision, in which hedgers can trade multiple risky assets with arbitrageurs. Arbitrageurs have 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.

JEL-codes: D53 G01 G11 G12 (search for similar items in EconPapers)
Date: 2014-02
New Economics Papers: this item is included in nep-rmg
Note: AP
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Citations: View citations in EconPapers (12)

Published as PÉTER KONDOR & DIMITRI VAYANOS, 2019. "Liquidity Risk and the Dynamics of Arbitrage Capital," The Journal of Finance, vol 74(3), pages 1139-1173.

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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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