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Fund Runs and Market Frictions

  • Kyoungwon Seo Associate Professor, Seoul National University
We study a simple model in which arbitrageurs trade assets in infinitely repeated stages and a financial crisis may occur due to redemption requests of investors on arbitrageurs. If the asset is undervalued, the arbitrageurs buy the asset to make profits. But the mispricing may become even larger in the next period and the arbitrageurs will take huge losses temporarily. Even though the asset price will recover its fundamental value in the end, the temporary losses of the arbitrageurs can force the arbitrageurs to liquidate the funds due to the redemption requests and stay away from the market in all the subsequent stages. Thus, patience of arbitrageurs (the relative weight to the future profits) affects possibility of a financial crisis. This paper shows two properties on the discount factor. First, a financial crisis without external shocks can arise only when arbitrageurs are impatient, and second, if such a crisis may arise, high patience of arbitrageurs mitigates the crisis but enlarges the pre-crisis mispricing. The model setup mimics the modern financial markets and some of them may be viewed as market frictions which prohibit market efficiency. The simplicity of the model allows a closed-form solution.

  • Kyoungwon Seo
We study a simple model in which arbitrageurs trade assets in infinitely repeated stages and a financial crisis may occur due to redemption requests of investors on arbitrageurs. If the asset is undervalued, the arbitrageurs buy the asset to make profits. But the mispricing may become even larger in the next period and the arbitrageurs will take huge losses temporarily. Even though the asset price will recover its fundamental value in the end, the temporary losses of the arbitrageurs can force the arbitrageurs to liquidate the funds due to the redemption requests and stay away from the market in all the subsequent stages. Thus, patience of arbitrageurs (the relative weight to the future profits) affects possibility of a financial crisis. This paper shows two properties on the discount factor. First, a financial crisis without external shocks can arise only when arbitrageurs are impatient, and second, if such a crisis may arise, high patience of arbitrageurs mitigates the crisis but enlarges the pre-crisis mispricing. The model setup mimics the modern financial markets and some of them may be viewed as market frictions which prohibit market efficiency. The simplicity of the model allows a closed-form solution.
Fund Run; Arbitrageurs; Discount Factor; Financial Crisis; Mispricing