Working Paper: NBER ID: w19931
Authors: Péter 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: Liquidity; Arbitrage; Risk Premia
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 |
|---|---|
| Hedgers' risk aversion (D81) | Arbitrageurs' risk aversion (D81) |
| Liquidity providers' capital (G33) | Asset pricing (G19) |
| Liquidity providers' capital (G33) | Aggregate illiquidity (G33) |
| Wealth of arbitrageurs (G19) | Return variances and covariances (C29) |