Liquidity Risk and the Dynamics of Arbitrage Capital

Dimitri Vayanos and Péter Kondor

No 9885, CEPR Discussion Papers from Centre for Economic Policy Research

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.

Keywords: Arbitrage capital; Asset pricing; Liquidity; Liquidity risk; Risk-sharing (search for similar items in EconPapers)
JEL-codes: D53 G01 G11 G12 (search for similar items in EconPapers)
Date: 2014-03
New Economics Papers: this item is included in nep-rmg and nep-upt
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Citations: View citations in EconPapers (12)

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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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