Risky Arbitrage and Collateral Policies
46 Pages Posted: 22 Aug 2014 Last revised: 9 Jan 2018
Date Written: October 4, 2017
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.
Keywords: collateral, financial constraints, systemic risk, liquidity, financial stability, incomplete markets
JEL Classification: C68
Suggested Citation: Suggested Citation