Working Papers

Arbitrage Crashes, Financial Accelerator, and Sudden Market Freezes” (2017)

We develop an infinite horizon model that links the intermediation in both the financial and real sectors. Intermediaries provide market liquidity and exploit the arbitrage profits in segmented financial markets. To do so, they use their productive capital as collateral. We show that the weakened intermediation and arbitrage losses are mutually reinforcing during an economic downturn. This forces intermediaries to de-lever and leads to liquidity spirals in both financial and real sectors. Also, the distress might further open up the possibility of sudden run-like market freezes, where intermediaries are denied access to renewed funding through arbitrage. We evaluate the effect of three intervention policies: direct purchase of distressed assets, interest rate cuts, and capital injection. We find that capital injection is most effective as it loosens the margin requirement. The interest cut is least effective because it exacerbates the capital misallocation.

Available at SSRN:

Presented or Accepted for Presentation at:

  • European Winter Meeting of the Econometric Society 2017, December 2017, Barcelona

The Arbitrage Cycle and the Business Cycle” (2019)

Previously circulated with the titles “Recovery Is Never Easy” and “Best Friend or Worst Enemy?”

We develop a general equilibrium model to study the transmission channel between arbitrage crashes and recessions in the aggregate economy. We assume that speculators are financially constrained and can securitize their capital investment as collateral. A shock triggers the regime shift and inflicts losses on arbitrageurs, forcing them to reduce their capital investment. This creates a scarcity of collateral for convergence trades and pushes the price spreads to diverge. Speculators thus experience the worst losses when arbitrage opportunities are most profitable. Such distress causes further contractions in the capital investment and aggregate output. We show that on one hand arbitrage activities allow the real sector investment to have extra shadow value serving as collateral, thereby boosting the overall production. However, the interaction between speculations and the business cycle also induces the transmission mechanism, where trivial shocks can spread, amplify and trigger simultaneous arbitrage crashes and recessions. By solving the closed-form model, we characterize the multiple equilibria to account for the nonlinear aspects of financial crises and the post-crisis recovery through regime shifts.

Available at SSRN:

Presented or Accepted for Presentation at:

  • The 50th Annual Conference of the Money, Macro & Finance, September 2018, Edinburgh, UK
  • EEA 2018, Aug 2018, Cologne, Germany
  • Lancaster University Management School, Feb 2018, Lancaster, UK
  • Warwick Business School, Jan 2018, Coventry, UK
  • Erasmus Management School, Jan 2018, Rotterdam, Netherlands
  • Groeningen University, Jan 2018, Groeningen, Netherlands
  • AFA 2018 Ph.D. Poster Session, Jan 2018, Philadelphia, US
  • Swiss Finance Institute Research Day 2017, June 2017, Gerzensee, Switzerland
  • RES Symposium of Junior Researchers, April 2017, University of Bristol, Bristol, UK
  • Institute for Banking & Finance Brown Bag Seminar, March 2017, University of Zürich, Zürich, Switzerland
  • European Winter Meeting of the Econometric Society 2016, December 2016, Edinburgh, UK

Risky Arbitrage and Collateral Policies” (2014)

Previously circulated with the title “Amplification and Spillover Effects with Arbitrage, Production and Collateral Constraints”

We construct a dynamic model economy in which investors from segmented markets have varying financial asset demands. Intermediaries make arbitrage profits by exploiting the price spreads across markets. Meanwhile, they are required to separately post collateral to support arbitrage trades. We show that with volatile asset demands, arbitrage becomes risky. With information frictions, a looser collateral policy might render the economy more vulnerable to extremely large demand shocks, while a tighter collateral constraint helps maintain the stability at the cost of market liquidity supply.

Available at SSRN:

Presented or Accepted for Presentation at:

  • Annual Conference of the Swiss Society for Financial Market Research, March 2017, Zürich
  • Royal Economic Society Ph.D. Meetings, January 2017, London
  • Institute for Banking & Finance Brown Bag Seminar, University of Zürich, September 2016, Zürich
  • Annual Meeting of the German Sociopolicital Association 2016, August 2016, Augsburg
  • Department of Economics Brown Bag Seminar, University of Zürich, September 2016, Zürich
  • 9th World Congress of the Bachelier Finance Society, July 2016, New York (two presentations, one by co-author)
  • Midwest Macro Meetings 2016, Mai 2016, Lafayette
  • Swiss Finance Institute Research Days 2014, June 2014, Gerzensee (early version entitled “Spillover and Amplification with Financially Constrained Intermediaries”)

“Analytical Option Pricing under an Asymmetrically Displaced Double Gamma Jump-Diffusion Model” (2013), joint with Matthias Thul

We generalize the Kou (2002) double exponential jump-diffusion model in two directions. First, we independently displace the two tails of the jump size distribution away from the origin. Second, we allow for each of the displaced tails to follow a gamma distribution with an integer-valued shape parameter. Both extensions introduce additional flexibility in the tails of the corresponding return distribution. Our model is supported by an equilibrium economy and we obtain closed-form solutions for European plain vanilla options. Our valuation function is computationally fast to evaluate and robust across the full parameter space. We estimate the physical model parameters through maximum likelihood and for a diverse sample of equities, commodities and exchange rates. For all assets under consideration, the original Kou (2002) model can be rejected in favor of our newly introduced asymmetrically displaced double gamma dynamics.

Available at SSRN:

Presented or Accepted for Presentation at:

  • University of New South Wales Brown Bag Seminar, April 2013, Sydney
  • 26th Australasian Finance & Banking Conference, December 2013, Sydney
  • Institute for Banking & Finance Brown Bag Seminar, March 2014, Zürich
  • Advances in Computational Economics and Finance, March 2014, Zürich
  • 11th German Probability and Statistics Days, March 2014, Ulm
  • Southwestern Finance Association 2014 Annual Conference, March 2014, Dallas
  • 50th Anniversary Meeting of the Eastern Finance Association, April 2014, Pittsburgh
    — The Chicago Trading Company Outstanding Paper in Derivatives Award —
  • 17th Annual Conference of the Swiss Society for Financial Market Research, April 2014, Zürich
  • 8th World Congress of the Bachelier Finance Society, June 2014, Brussels
  • 2014 FMA European Conference, June 2014, Maastricht

Recent Posts

FAQs for the AD-DG Model

In a recent working paper, cited as Thul and Zhang (2014) below, we propose a novel jump-diffusion model whose jump sizes follow an asymmetrically displaced double gamma (AD-DG) distribution. In this blog post I discuss some of the feedback that we received during seminar and conference presentations. The collection is not exhaustive and will be extended from time to time.

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  1. Stochastic Volatility with AD-DG Jumps Leave a reply