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

Abstract

Will arbitrage capital flow into a market experiencing a liquidity shock, mitigating the adverse effect of the shock on liquidity? Using a stochastic dynamic model of equilibrium pricing with privately informed capital-constrained arbitrageurs, we show that arbitrage capital may actually flow out of the illiquid market. When some arbitrage 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.