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

Abstract

Will arbitrage capital flow into a market experiencing a 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 informed capital may actually flow out of that market. The remaining informed capital in the market becomes trapped because pricing becomes too inefficient for informed 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.