Amsterdam TI Finance Research Seminars

Dimitri Vayanos (London School of Economics, United Kingdom)
Wednesday, 18 May 2016
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. Arbitrageurs increase their positions following high asset returns, and can choose to provide less insurance when hedgers are more risk-averse. The stationary distribution of arbitrageur wealth is bimodal when hedging needs are strong. Liquidity is increasing in arbitrageur wealth, while asset volatilities, correlations, and expected returns are hump-shaped. Assets that suffer the most when aggregate liquidity decreases offer the  highest expected returns. This is because the arbitrageurs’ portfolio is a pricing factor, and aggregate liquidity captures exactly that factor. Joint with Péter Kondor (London School of Economics and CEPR).