The dynamics of financially constrained arbitrage

Gromb, Denis and Vayanos, Dimitri ORCID: 0000-0002-0944-4914 (2015) The dynamics of financially constrained arbitrage. Systemic Risk Centre Discussion Papers (32). Systemic Risk Centre, The London School of Economics and Political Science, London, UK.

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Abstract

We develop a model of financially constrained arbitrage, and use it to study the dynamics of arbitrage capital, liquidity, and asset prices. Arbitrageurs exploit price discrepancies between assets traded in segmented markets, and in doing so provide liquidity to investors. A collateral constraint limits their positions as a function of capital. We show that the dynamics of arbitrage activity are self-correcting: following a shock that depletes arbitrage capital, profitability increases, and this allows capital to be gradually replenished. Spreads increase more and recover faster for more volatile trades, although arbitrageurs cut their positions in these trades the least. When arbitrage capital is more mobile across markets, liquidity in each market generally becomes less volatile, but the reverse may hold for aggregate liquidity because of mobility-induced contagion.

Item Type:	Monograph (Discussion Paper)
Official URL:	https://www.systemicrisk.ac.uk/
Additional Information:	© 2015 The Authors
Divisions:	Finance
Subjects:	H Social Sciences > HC Economic History and Conditions H Social Sciences > HG Finance
JEL classification:	D - Microeconomics > D5 - General Equilibrium and Disequilibrium > D52 - Incomplete Markets D - Microeconomics > D5 - General Equilibrium and Disequilibrium > D53 - Financial Markets G - Financial Economics > G1 - General Financial Markets > G11 - Portfolio Choice; Investment Decisions G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing; Trading volume; Bond Interest Rates G - Financial Economics > G1 - General Financial Markets > G14 - Information and Market Efficiency; Event Studies G - Financial Economics > G2 - Financial Institutions and Services > G23 - Pension Funds; Other Private Financial Institutions
Date Deposited:	05 Jul 2023 10:27
Last Modified:	11 Dec 2024 19:46
URI:	http://eprints.lse.ac.uk/id/eprint/119012

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