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Arbitrage and Beliefs

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  • Paymon Khorrami
  • Alexander K. Zentefis

Abstract

We study a segmented-markets setting in which self-fulfilling volatility can arise. The only requirements are (i) asset price movements redistribute wealth across markets (e.g., equities rise as bonds fall) and (ii) some stabilizing force keeps valuation ratios stationary (e.g., cash flow growth rises when valuations rise). We prove that when self-fulfilling volatility exists, arbitrage opportunities must also exist. Conversely, at times when arbitrage profits exist, asset markets are susceptible to self-fulfilling fluctuations. The tight theoretical connection between price volatility and arbitrage is detectable in currency markets by studying deviations from covered interest parity.

Suggested Citation

  • Paymon Khorrami & Alexander K. Zentefis, 2020. "Arbitrage and Beliefs," CESifo Working Paper Series 8490, CESifo.
    • Handle: RePEc:ces:ceswps:_8490
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    References listed on IDEAS

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    Cited by:

    1. Paymon Khorrami & Fernando Mendo, 2021. "Rational Sentiments and Financial Frictions," Working Papers Central Bank of Chile 928, Central Bank of Chile.

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    More about this item

    Keywords

    limits to arbitrage; segmented markets; volatility; self-fulfilling prices; multiple equilibria; covered interest parity;
    All these keywords.

    JEL classification:

    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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