A Study of Financial Market Frictions and Their Impacts on Financial Intermediaries and the Macroeconomy

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This research looks into the market frictions that prevent sufficient arbitrage activity and could possibly lead to financial market fragility and severe crisis. Arbitrage refers to the practice of exploiting mispricing opportunities, which is conducted by rational and sophisticated investors, e.g. hedge funds. Effective arbitrage ensures that the financial market infrastructure is efficient and well-functioning, which is critical to the UK economy and productivity. However, due to several market frictions such as risk management, fee structure and funding constraint faced by fund managers, arbitrage is limited, mispricings persist, and more severely financial crises can be triggered. Extensive research on limits to arbitrage have been carried out with focus on the size of mispricing, but many questions and limitations are unsolved: (i) what is the combined impact of various arbitrage frictions on market efficiency; (ii) what is the dominating friction that limits arbitrage at a certain period; (iii) whether it is possible to identify the potential market vulnerability from data. Answering these questions is crucial to the policy-makers, e.g. Bank of England, in supervising and regulating the financial market infrastructures to ensure a smooth functioning of the UK economy and making appropriate monetary policy to influence activities in the economy. In keeping with the fast-developing financial market and the vast demand for appropriate supervision, understanding of what lies behind the limits to arbitrage requires more knowledge of market dynamics. To address these issues, this research conducts theoretical studies and empirical applications to analyze the two distinct market frictions that limit arbitrage: cost/risk management and funding (il)liquidity. Large arbitrage costs render arbitrageurs unwilling to conduct arbitrage, while funding illiquidity reduces their ability to raise sufficient funds to conduct arbitrage. Under certain conditions, severe funding illiquidity triggers the amplification machanism that describes how a moderate event can propagate into a large spillover across the financial system. From the theoretical aspect, the research proposes to investigate market frictions via the arbitrage activity implemented to correct mispricing. First, it reveals the combined effect of the market frictions on the arbitrage activity and asset pricing dynamics, which offers an novel approach to identify the dominating friction of the two, and more importantly, to measure the level of funding illiquidity in the market and signal the occurrence of amplification. By the empirical application in the US market, the results demonstrate the dominance of funding illiquidity and the existence of amplification effect during the major financial crises events in recent years, which provides an early warning signal of potential failure in financial market infrastructure and guides the direction and timing of the policy decision.Throughout this fellowship, efforts will be made to further enhance this research: consulting with real life arbitrageurs, e.g. hedge funds, to understand how market frictions tend to affect their activity and how they overcome these frictions; communicating with policy-makers and regulators, e.g. Bank of England, to understand their opinions on market frictions and identify the information in need. Efforts will also be made to disseminate the finding of this research to potential users and beneficiaries through conference presentation, journal publication, networking, research visit, social media coverage and report disclosed in web page.