Financially Constrained Strategic Arbitrage

We develop an equilibrium model of strategic trading under financial constraints. Investors have access to a fundamentally riskless arbitrage opportunity, but may be forced to fire-sell if their capital does not fully cover their losses. Investors internalize both their price impact and the effect of price movements on the constraints of all market participants, giving rise to a strategic motive for the less exposed investors to induce fire-sales of more exposed ones. Ex ante, the presence of predatory risk leads to lower investment by all traders. We show the implications of strategic trading on price dynamics, returns characteristics, and leverage cross-section and dynamics.