Liquidity Risk and the Dynamics of Arbitrage Capital

103 Pages Posted: 24 Feb 2014 Last revised: 18 Jun 2023

See all articles by Peter Kondor

Peter Kondor

London School of Economics & Political Science (LSE); Central European University (CEU)

Dimitri Vayanos

London School of Economics; Center for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: February 2014

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.

Suggested Citation

Kondor, Peter and Kondor, Peter and Vayanos, Dimitri, Liquidity Risk and the Dynamics of Arbitrage Capital (February 2014). NBER Working Paper No. w19931, Available at SSRN: https://ssrn.com/abstract=2400276

Peter Kondor (Contact Author)

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Central European University (CEU) ( email )

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Dimitri Vayanos

London School of Economics ( email )

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Center for Economic Policy Research (CEPR)

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National Bureau of Economic Research (NBER)

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