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Inference, arbitrage, and asset price volatility

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Adrian, Tobias

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Abstract

Does the presence of arbitrageurs decrease equilibrium asset price volatility? I study an economy with arbitrageurs, informed investors, and noise traders. Arbitrageurs face a trade-off between "inference" and "arbitrage": they would like to buy assets in response to temporary price declines--the arbitrage effect--but sell when prices decline permanently--the inference effect. In equilibrium, the presence of arbitrageurs increases volatility when the inference effect dominates the arbitrage effect. From a technical point of view, the paper offers closed form solutions to a dynamic equilibrium model with asymmetric information and non-Gaussian priors.

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File URL: http://www.sciencedirect.com/science/article/B6WJD-4SW144W-1/2/0073a1fd110fe9fca85641e6a0f93661
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Publisher Info
Article provided by Elsevier in its journal Journal of Financial Intermediation.

Volume (Year): 18 (2009)
Issue (Month): 1 (January)
Pages: 49-64
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Handle: RePEc:eee:jfinin:v:18:y:2009:i:1:p:49-64

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Web page: http://www.elsevier.com/locate/inca/622875

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Related research
Keywords: Asset pricing Learning Asymmetric information Limits to arbitrage;

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References listed on IDEAS
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  6. Jun Liu, 2004. "Losing Money on Arbitrage: Optimal Dynamic Portfolio Choice in Markets with Arbitrage Opportunities," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 17(3), pages 611-641. [Downloadable!] (restricted)
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