Working Paper: CEPR ID: DP9885
Authors: Peter Kondor; Dimitri Vayanos
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.
Keywords: Arbitrage Capital; Asset Pricing; Liquidity; Liquidity Risk; Risk Sharing
JEL Codes: D53; G01; G11; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| adverse shocks to the capital of liquidity providers (F65) | liquidity decline (G33) |
| adverse shocks to the capital of liquidity providers (F65) | risk premia increase (G19) |
| capital of liquidity providers (G15) | liquidity (E41) |
| capital of liquidity providers (G15) | risk premia (G22) |
| increase in hedgers' risk aversion (D81) | arbitrageurs become more risk-averse (G40) |
| capital of liquidity providers (G15) | expected returns on assets (G12) |
| wealth of arbitrageurs (G19) | expected returns on assets (G12) |
| covariance with the portfolio of arbitrageurs (C10) | expected returns on assets (G12) |