Leverage and Liquidity Dry-ups: A Framework and Policy Implications
نویسندگان
چکیده
We model financial market liquidity as provided by financially constrained arbitrageurs. Market liquidity increases with the level of arbitrage capital, i.e., internal and external capital arbitrageurs can access frictionlessly. We show that liquidity dry-ups follow periods of low returns of arbitrageurs’ risky investment opportunities, and that liquidity is correlated across markets. A welfare analysis reveals that arbitrageurs may fail take socially optimal positions in their investment opportunities, adversely affecting their ability to provide market liquidity. Finally, we discuss possible policy responses.
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