Arbitrage Crashes, Financial Accelerator, and Sudden Market Freezes
36 Pages Posted: 11 Sep 2017 Last revised: 9 Jan 2018
Date Written: November 18, 2017
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: Suggested Citation