DP9885 Liquidity Risk and the Dynamics of Arbitrage Capital

Author(s): Péter Kondor, Dimitri Vayanos
Publication Date: March 2014
Keyword(s): Arbitrage capital, Asset pricing, Liquidity, Liquidity risk, Risk-sharing
JEL(s): D53, G01, G11, G12
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=9885

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.