Journal of Finance Vol. 74 No. 3 2019

Liquidity Risk and the Dynamics of Arbitrage Capital

Péter Kondor^1,2; Dimitri Vayanos^3,4,2

¹ Central European University · ² London School of Economics and Political Science · ³ Center for Economic and Policy Research · ⁴ National Bureau of Economic Research

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.

DOI

10.1111/jofi.12757

Volume

74

Issue

3

Pages

1139-1173

Language

en

Sources

bibtex:phds-export.bib openalex crossref

Cite

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