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Risk in Dynamic Arbitrage: The Price Effects of Convergence Trading

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  • PÉTER KONDOR

Abstract

I develop an equilibrium model of convergence trading and its impact on asset prices. Arbitrageurs optimally decide how to allocate their limited capital over time. Their activity reduces price discrepancies, but their activity also generates losses with positive probability, even if the trading opportunity is fundamentally riskless. Moreover, prices of identical assets can diverge even if the constraints faced by arbitrageurs are not binding. Occasionally, total losses are large, making arbitrageurs' returns negatively skewed, consistent with the empirical evidence. The model also predicts comovement of arbitrageurs' expected returns and market liquidity. Copyright (c) 2009 the American Finance Association.

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Bibliographic Info

Article provided by American Finance Association in its journal The Journal of Finance.

Volume (Year): 64 (2009)
Issue (Month): 2 (04)
Pages: 631-655

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Handle: RePEc:bla:jfinan:v:64:y:2009:i:2:p:631-655

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Cited by:
  1. Ricardo Lagos & Guillaume Rocheteau & Pierre-Olivier Weill, 2009. "Crises and Liquidity in Over-the-Counter Markets," NBER Working Papers 15414, National Bureau of Economic Research, Inc.
  2. Patrick Bolton & Tano Santos & Jose A. Scheinkman, 2011. "Outside and Inside Liquidity," The Quarterly Journal of Economics, Oxford University Press, vol. 126(1), pages 259-321.
  3. Wei Xiong, 2013. "Bubbles, Crises, and Heterogeneous Beliefs," NBER Working Papers 18905, National Bureau of Economic Research, Inc.
  4. Babatunde Buraimo & David Peel & Rob Simmons, 2013. "Systematic Positive Expected Returns in the UK Fixed Odds Betting Market: An Analysis of the Fink Tank Predictions," International Journal of Financial Studies, MDPI, Open Access Journal, vol. 1(4), pages 168-182, December.
  5. Bernardo, Antonio E. & Welch, Ivo, 2013. "Leverage and preemptive selling of financial institutions," Journal of Financial Intermediation, Elsevier, vol. 22(2), pages 123-151.
  6. Cai, Charlie X. & McGuinness, Paul B. & Zhang, Qi, 2011. "The pricing dynamics of cross-listed securities: The case of Chinese A- and H-shares," Journal of Banking & Finance, Elsevier, vol. 35(8), pages 2123-2136, August.
  7. Douglas W. Diamond & Raghuram G. Rajan, 2009. "Fear of Fire Sales and the Credit Freeze," NBER Working Papers 14925, National Bureau of Economic Research, Inc.
  8. Liu, Jun & Timmermann, Allan G, 2009. "Risky Arbitrage Strategies: Optimal Portfolio Choice and Economic Implications," CEPR Discussion Papers 7188, C.E.P.R. Discussion Papers.
  9. Alsayed, Hamad & McGroarty, Frank, 2012. "Arbitrage and the Law of One Price in the market for American depository receipts," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 22(5), pages 1258-1276.
  10. Markus K. Brunnermeier & Martin Oehmke, 2012. "Bubbles, Financial Crises, and Systemic Risk," NBER Working Papers 18398, National Bureau of Economic Research, Inc.
  11. Kapadia, Nikunj & Pu, Xiaoling, 2012. "Limited arbitrage between equity and credit markets," Journal of Financial Economics, Elsevier, vol. 105(3), pages 542-564.

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