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The dynamics of financially constrained arbitrage

Gromb, Denis and Vayanos, Dimitri (2015) The dynamics of financially constrained arbitrage. SRC Discussion Paper (No 32). Systematic 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: http://www.systemicrisk.ac.uk
Additional Information: © 2015 The Authors
Divisions: Systemic Risk Centre
Subjects: H Social Sciences > HB Economic Theory
JEL classification: G - Financial Economics > G1 - General Financial Markets
G - Financial Economics > G2 - Financial Institutions and Services
Sets: Research centres and groups > Systemic Risk Centre
Date Deposited: 19 May 2015 11:45
Last Modified: 15 May 2019 23:22
Projects: ES/K002309/1
Funders: Economic and Social Research Council
URI: http://eprints.lse.ac.uk/id/eprint/62007

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