PDF Ebook Financially Constrained Arbitrage and Cross-Market Contagion
The ongoing crisis has highlighted the importance of intermediary capital for the functioning of financial markets. Indeed, the large losses banks incurred in the subprime market has led them to cut their lending across the board, notably their financing of other intermediaries, causing liquidity to dry up in many otherwise unrelated markets. Central banks the world around struggled to deal with a combined banking liquidity and financial market liquidity crisis. This paper develops a framework to examine the relation between intermediary capital, financial market liquidity and asset prices. The framework itself has three main features.
First, we model arbitrageurs as specialized investors able to exploit profitable trades that other, less sophisticated market participants cannot access directly as easily or quickly. Arbitrageurs are to be understood here as individuals and institutions responsible for providing liquidity in different financial markets. At the same time, arbitrage is assumed to require capital to which arbitrageurs have only limited access, i.e., they face financial constraints. These financial constraints, be they margin requirements, limited access to external capital or barriers to entry of new capital, affect the arbitrageurs’ investment capacity.
Second, ours is a dynamic general equilibrium model. On the one hand, arbitrageurs’ capital affects their ability to provide liquidity, which is ultimately reflected in asset prices. On the other hand, asset price movements determine arbitrage profits and, therefore, arbitrageurs’ capital. Thisdynamic interaction shapes arbitrageurs’ investment policies, asset prices and market liquidity.
Third, in our model, arbitrageurs face multiple arbitrage opportunities with different characteristics, across which they must allocate their scarce capital. This aspect is important to study the cross-sectional properties of arbitrageurs’ optimal investment policy, as well as those of market liquidity and asset prices. In particular, it allows us to analyze phenomena of price contagion and liquidity linkages across markets.
We aim to analyze a number of questions relative to arbitrageurs’ investment strategy. To start with, what is the optimal investment strategy of an arbitrageur with financial constraints? How is the need for risk management created by financial constraints resolved when there are multiple arbitrage opportunities with different characteristics? How does an arbitrageur’s optimal investment policy respond to shocks to their capital?
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PDF Ebook Financially Constrained Arbitrage and Cross-Market Contagion
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