Arbitrage Run and Collateral Run

38 Pages Posted: 11 Sep 2017 Last revised: 14 Nov 2019

See all articles by Ally Zhang

Ally Zhang

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

Date Written: November 18, 2017

Abstract

We investigate the channel through which fluctuations in the market liquidity of real-sector repo collateral cause arbitrage crashes and failure of systemically important intermediaries during the global financial crisis. Intermediaries pledge productive capital as repo collateral to fund the margin for their arbitrage positions. A tiny drop in the market liquidity of capital induces higher haircuts and forces arbitrageurs to collectively unwind trading positions, resulting in adverse price movements and losses. This further reduces the collateral value of arbitrage portfolios and triggers more fire-sales in both capital and arbitrage trades. This channel creates stronger amplification effects than in Brunnermeier and Pedersen (2009), and can easily incur a simultaneous repo run and arbitrage crashes, where liquidity in several markets dry up altogether. We also show that "flight-to-liquidity'' effects in intermediaries' collateral choices after the repo run prolong the real-sector recession.

Keywords: limit of arbitrage, financial intermediary, haircut, segmented markets, financial crises, market liquidity, collateral constraints

JEL Classification: D52, D58, E44, G01, G12, G33

Suggested Citation

Zhang, Quan, Arbitrage Run and Collateral Run (November 18, 2017). Swiss Finance Institute Research Paper No. 17-62, Available at SSRN: https://ssrn.com/abstract=3034291 or http://dx.doi.org/10.2139/ssrn.3034291

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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