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Loews Philadelphia, Commonwealth Hall B
Hosted By:
American Finance Association
Liquidity: Theoretical Models
Paper Session
Sunday, Jan. 7, 2018 1:00 PM - 3:00 PM
- Chair: Hengjie Ai, University of Minnesota
Pricing and Liquidity in Decentralized Asset Markets
Abstract
I develop a search-and-bargaining model of liquidity provision in over-the-counter markets where investors differ in their search intensities. A distinguishing characteristic of my model is its tractability: it allows for heterogeneity, unrestricted asset positions, and fully decentralized trade. I find that investors with higher search intensities (i.e., fast investors) are less averse to holding inventories and more attracted to cash earnings, which makes the model corroborate a number of stylized facts that do not emerge from existing models: (i) fast investors provide intermediation by charging a speed premium, and (ii) fast investors hold larger and more volatile inventories. The model has also new empirical implications about the effect of trading frictions on the supply and price of liquidity.Hedge Funds, Signaling, and Optimal Lockups
Abstract
Many hedge funds restrict investors' ability to redeem their investments. We show that lockups alleviate a delegation friction. In our model hedge funds can trade a long-term arbitrage opportunity; doing so increases expected returns but lowers short-term returns. Investors who rationally learn from returns may mistake a skilled manager who pursues the arbitrage opportunity for an unskilled manager. Skilled managers therefore have an incentive to avoid redemptions by distorting their portfolios to enhance short-term returns. The tradeoff between the ability to trade the arbitrage opportunity more aggressively and investors' fears of being stuck with an unskilled manager determines the optimal lockup. We calibrate the model to hedge fund data and show that arbitrage remains limited even with optimal lockups; the average manager sacrifices 78 basis points in expected returns per year to improve short-term returns.ETF Arbitrage Under Liquidity Mismatch
Abstract
A natural liquidity mismatch emerges when liquid exchange traded funds (ETFs) hold relatively illiquid assets. We provide a theory and empirical evidence showing that this liquidity mismatch can reduce market efficiency and increase the fragility of these ETFs. We focus on corporate bond ETFs and examine the role of authorized participants (APs) in ETF arbitrage. In addition to their role as dealers in the underlying bond market, APs also play a unique role in arbitrage between the bond and ETF markets since they are the only market participants that can trade directly with ETF issuers. Using novel and granular AP-level data, we identify a conflict between APs’ dual roles as bond dealers and as ETF arbitrageurs. When this conflict is small, liquidity mismatch reduces the arbitrage capacity of ETFs; as the conflict increases, an inventory management motive arises that may even distort ETF arbitrage, leading to large relative mispricing. These findings suggest an important risk in ETF arbitrage.Discussant(s)
Pierre-Olivier Weill
,
University of California-Los Angeles
Ana Babus
,
Federal Reserve Bank of Chicago
Hong Liu
,
Washington University-St. Louis
Haoxiang Zhu
,
Massachusetts Institute of Technology
JEL Classifications
- G1 - General Financial Markets