Liquidity Risk and the Dynamics of Arbitrage Capital

Liquidity Risk and the Dynamics of Arbitrage Capital

  • PÉTER KONDOR
  • DIMITRI VAYANOS

Article first published online: 11th February 2019 DOI: 10.1111/jofi.12757

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.

Sign in to access the full article.

Are you an Author?


Please read our submission requirements and find out how to submit your paper to the Journal of Finance

Submit a paper