Liquidity risk and the dynamics of arbitrage capital

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: We develop a continuous-time model of liquidity provision in which hedgers can trade multiple risky assets with arbitrageurs. Arbitrageurs have constant relative risk-aversion (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: liquidity risk; wealth effects; heterogeneous agents; intermediary asset pricing; endogenous risk (search for similar items in EconPapers)
JEL-codes: F3 G3 (search for similar items in EconPapers)
Pages: 35 pages
Date: 2019-06-01
New Economics Papers: this item is included in nep-cwa, nep-dge, nep-ore, nep-rmg and nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (19)

Published in Journal of Finance, 1, June, 2019, 74(3), pp. 1139-1173. ISSN: 0022-1082

Downloads: (external link)
http://eprints.lse.ac.uk/87520/ Open access version. (application/pdf)

Related works:
Journal Article: 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)
Working Paper: Liquidity Risk and the Dynamics of Arbitrage Capital (2014)
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