The Behavior of an Institutional Investor with Arbitrage Opportunities and Liquidity Risk

Sangwook Sung, Hoon Cho and Doojin Ryu

Emerging Markets Finance and Trade, 2019, vol. 55, issue 1, 1-12

Abstract: This study analyzes the efficiency of liquidity flows in stabilizing distressed markets from a theoretical perspective. We show that even in the event of a major negative market shock, a financial institution can increase its investment in the market when there is a strong incentive for arbitrage profit. However, the institution may choose to reduce its investment if the fear from liquidity risk exceeds the arbitrage incentive. In addition, our model reveals a positive relationship between funding liquidity and market liquidity. Our findings help to explain several financial issues in distressed markets, including the flight to quality, liquidity dry-ups, asset fire sales, and market shock amplifications.

Date: 2019
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Persistent link: https://EconPapers.repec.org/RePEc:mes:emfitr:v:55:y:2019:i:1:p:1-12

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DOI: 10.1080/1540496X.2018.1498333

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