Risky arbitrage and collateral policies

Ally Quan Zhang (Swiss Finance Institute and Department of Banking & Finance, Universität Zürich)

We construct a dynamic model economy in which investors from segmented markets have varying financial asset demands. Intermediaries make arbitrage profits by exploiting the price spreads across markets. Meanwhile, they are required to separately post collateral to support arbitrage trades. We show that with volatile asset demands, arbitrage becomes risky. With information frictions, a looser collateral policy might render the economy more vulnerable to extremely large demand shocks, while a tighter collateral constraint helps maintain the stability at the cost of market liquidity supply

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Year of publication:	October 6, 2017 ; Last Update: October 6, 2017
Authors:	Zhang, Ally Quan
Publisher:	[Geneva] : Swiss Finance Institute
Subject:	collateral \| financial constraints \| systemic risk \| liquidity \| financial stability \| incomplete markets \| Kreditsicherung \| Collateral \| Unvollkommener Markt \| Incomplete market \| Theorie \| Theory \| Finanzmarkt \| Financial market \| Finanzkrise \| Financial crisis \| Systemrisiko \| Systemic risk \| Liquiditätsbeschränkung \| Liquidity constraint \| Liquidität \| Liquidity \| Bankrisiko \| Bank risk \| Kreditrisiko \| Credit risk \| Arbitrage \| Arbitrage Pricing \| Arbitrage pricing \| Kreditrationierung \| Credit rationing \| Bankenliquidität \| Bank liquidity