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The Dynamics of Financially Constrained Arbitrage

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  • DENIS GROMB
  • DIMITRI VAYANOS

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, which 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.

Suggested Citation

  • Denis Gromb & Dimitri Vayanos, 2018. "The Dynamics of Financially Constrained Arbitrage," Journal of Finance, American Finance Association, vol. 73(4), pages 1713-1750, August.
    • Handle: RePEc:bla:jfinan:v:73:y:2018:i:4:p:1713-1750
    DOI: 10.1111/jofi.12689
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    More about this item

    JEL classification:

    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • G01 - Financial Economics - - General - - - Financial Crises
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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