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The dynamics of financially constrained arbitrage

Gromb, Denis and Vayanos, Dimitri (2018) The dynamics of financially constrained arbitrage. Journal of Finance, 73 (4). pp. 1713-1750. ISSN 0022-1082

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Identification Number: 10.1111/jofi.12689

Abstract

We develop a model in which financially constrained arbitrageurs exploit price discrepancies across segmented markets. We show that the dynamics of arbitrage capital are self-correcting: following a shock that depletes capital, returns increase, and this allows capital to be gradually replenished. Spreads increase more for trades with volatile fundamentals or more time to convergence. Arbitrageurs cut their positions more in those trades, except when volatility concerns the hedgeable component. Financial constraints yield a positive cross-sectional relationship between spreads/returns and betas with respect to arbitrage capital. Diversification of arbitrageurs across markets induces contagion, but generally lowers arbitrageurs’ risk and price volatility.

Item Type: Article
Official URL: http://onlinelibrary.wiley.com/journal/10.1111/(IS...
Additional Information: © 2017 The Authors
Divisions: Finance
Subjects: H Social Sciences > HG Finance
Sets: Departments > Finance
Date Deposited: 23 Aug 2017 11:28
Last Modified: 20 Nov 2019 05:24
URI: http://eprints.lse.ac.uk/id/eprint/84081

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