Arbitrage Crashes, Financial Accelerator, and Sudden Market Freezes

36 Pages Posted: 11 Sep 2017 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: November 18, 2017

Abstract

We develop an infinite horizon model that links the intermediation in both the financial and real sectors. Intermediaries provide market liquidity and exploit the arbitrage profits in segmented financial markets. To do so, they use their productive capital as collateral. We show that the weakened intermediation and arbitrage losses are mutually reinforcing during an economic downturn. This forces intermediaries to de-lever and leads to liquidity spirals in both financial and real sectors. Also, the distress might further open up the possibility of sudden run-like market freezes, where intermediaries are denied access to renewed funding through arbitrage. We evaluate the effect of three intervention policies: direct purchase of distressed assets, interest rate cuts, and capital injection. We find that capital injection is most effective as it loosens the margin requirement. The interest cut is least effective because it exacerbates the capital misallocation.

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 Crashes, Financial Accelerator, and Sudden Market Freezes (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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