Liquidity Risk and the Dynamics of Arbitrage Capital

65 Pages Posted: 2 Jun 2014

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: March 2014

Abstract

We develop a dynamic model of liquidity provision, in which hedgers can trade multiple risky assets with arbitrageurs. We compute the equilibrium in closed form when arbitrageurs' utility over consumption is logarithmic or risk-neutral with a non-negativity constraint. Liquidity is increasing in arbitrageur wealth, while asset volatilities, correlations, and expected returns are hump-shaped. Liquidity is a priced risk factor: assets that suffer the most when liquidity decreases, e.g., those with volatile cashflows or in high supply by hedgers, offer the highest expected returns. When hedging needs are strong, arbitrageurs can choose to provide less liquidity even though liquidity provision is more profitable.

Keywords: Arbitrage capital, Asset pricing, Liquidity, Liquidity risk, Risk-sharing

JEL Classification: D53, G01, G11, G12

Suggested Citation

Kondor, Peter and Kondor, Peter and Vayanos, Dimitri, Liquidity Risk and the Dynamics of Arbitrage Capital (March 2014). CEPR Discussion Paper No. DP9885, Available at SSRN: https://ssrn.com/abstract=2444906

Peter Kondor (Contact Author)

London School of Economics & Political Science (LSE) ( email )

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HOME PAGE: http://fmg.lse.ac.uk/~kondor

Central European University (CEU) ( email )

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Budapest, H-1051
Hungary

Dimitri Vayanos

London School of Economics ( email )

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+44 (0)20 7955 6382 (Phone)
+44 (0)20 7955 7420 (Fax)

Center for Economic Policy Research (CEPR)

London
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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