Why is capital slow moving? Liquidity hysteresis and the dynamics of limited arbitrage

Francesco Sangiorgi James Dow, Jungsuk Han - Sep 20, 2018

Will arbitrage capital flow into a market experiencing a liquidity shock, mitigating the adverse effect of the shock on price efficiency? Using a
stochastic dynamic equilibrium model with privately informed capital-constrained arbitrageurs, we show that arbitrage capital may
actually flow out of the illiquid market. When some capital flows out, the remaining capital in the market becomes trapped because it becomes
too illiquid for arbitrageurs to want to close out their positions. This mechanism creates endogenous liquidity regimes under which temporary shocks
can trigger flight-to-liquidity resulting in ``liquidity hysteresis'' which is a persistent shift in market liquidity and price informativeness.

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