Financially Constrained Arbitrage & the Cross-Section of Market Liquidity (FEVAY)

FEVAY is a study contract with the Banque de France, led by Denis Gromb (London Business School and CEPR) and Dimitri Vayanos (London School of Economics and CEPR)

The project aims to develop a model of financial markets that accounts for the financial constraints faced by arbitrageurs in a realistic yet tractable way. The focus would be on deriving testable implications for liquidity across different financial markets.

In financial markets, liquidity is provided by specialized agents, referred to as arbitrageurs in finance textbooks, and which include hedge funds, dealers, and investment banks. Contrary to their textbook counterparts, real-life arbitrageurs do face financial constraints. That is, arbitrageurs' capacity to invest, and thereby their ability to provide liquidity to others, depend on their capital and on the margins charged by their financiers. Understanding the effect of these constraints is therefore important to a theory of asset pricing and market liquidity. The 1998 financial crisis illustrated the importance of financially constrained arbitrage. Before the crisis, many hedge funds had bet on the prices of comparable securities eventually converging. In the crisis, as prices instead diverged, these funds incurred heavy losses and had to liquidate many of their positions, despite these being generally viewed as profitable in the long run. In turn, the liquidations disrupted financial markets, with asset prices diverging further away from fundamentals, and liquidity drying out as the chain of losses and liquidations propagated across different markets.

The financial health of key traders has also important welfare and policy implications. For example, in the 1998 Asian crisis, the positions of LTCM, a major hedge fund and one of the worst hit, were so large that their liquidation was feared to depress prices so much as to jeopardize the financial system at large, not only those markets in which LTCM was invested. This led the Federal Reserve to organize LTCM's rescue.