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.