Risky Arbitrage and Collateral Policies

46 Pages Posted: 22 Aug 2014 Last revised: 9 Jan 2018

See all articles by Ally Zhang

Ally Zhang

Department of Finance, Lancaster University Management School; Swiss Finance Institute

Date Written: October 4, 2017

Abstract

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

Zhang, Quan, Risky Arbitrage and Collateral Policies (October 4, 2017). Swiss Finance Institute Research Paper No. 17-56, Available at SSRN: https://ssrn.com/abstract=2485099 or http://dx.doi.org/10.2139/ssrn.2485099

Quan Zhang (Contact Author)

Department of Finance, Lancaster University Management School ( email )

Economics Department,
LUMS,
Bailrigg Lancaster, LA1 4YX
United Kingdom
+441524592776 (Phone)

HOME PAGE: http://www.allyquanzhang.com/wordpress/

Swiss Finance Institute ( email )

Plattenstrasse 32
Zurich, ZH 8032
Switzerland

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