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Arbitrage Crashes, Financial Accelerator, and Sudden Market Freezes

Author

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  • Ally Zhang

    (University of Zurich and Swiss Finance Institute)

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.

Suggested Citation

  • Ally Zhang, 2017. "Arbitrage Crashes, Financial Accelerator, and Sudden Market Freezes," Swiss Finance Institute Research Paper Series 17-62, Swiss Finance Institute, revised Jan 2018.
    • Handle: RePEc:chf:rpseri:rp1762
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    More about this item

    Keywords

    limit of arbitrage; financial intermediary; haircut; segmented markets; financial crises; market liquidity; collateral constraints;
    All these keywords.

    JEL classification:

    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • D58 - Microeconomics - - General Equilibrium and Disequilibrium - - - Computable and Other Applied General Equilibrium Models
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G01 - Financial Economics - - General - - - Financial Crises
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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