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Arbitrage networks

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  • Rahi, Rohit
  • Zigrand, Jean-Pierre

Abstract

This paper is studies the general equilibrium implications of arbitrage trades by strategic players in segmented financial markets. Arbitrageurs exploit client`ele effects and choose to specialize in one category of trades, taking into consideration all other arbitrage strategies. This results in an equilibrium network of arbitrageurs. The optimal network for arbitrageurs is of the hub-spoke kind. The equilibrium network, in contrast, is never optimal for arbitrageurs and is never hub-spoke. The reason is that equilibrium networks suffer from a Prisoner’s Dilemma problem that prevents network externalities from being internalized. We show that, as the number of intermediaries grows, equilibrium allocations converge to those of the frictionless complete-markets Arrow-Debreu economy.

Suggested Citation

  • Rahi, Rohit & Zigrand, Jean-Pierre, 2008. "Arbitrage networks," LSE Research Online Documents on Economics 4787, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:4787
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    File URL: http://eprints.lse.ac.uk/4787/
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    References listed on IDEAS

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    9. Rodrigo Cifuentes & Hyun Song Shin & Gianluigi Ferrucci, 2005. "Liquidity Risk and Contagion," Journal of the European Economic Association, MIT Press, vol. 3(2-3), pages 556-566, 04/05.
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    Cited by:

    1. Rod Cross & Victor Kozyakin & Brian O'Callaghan & Alexei Pokrovskii & Alexey Pokrovskiy, 2012. "Periodic Sequences Of Arbitrage: A Tale Of Four Currencies," Metroeconomica, Wiley Blackwell, vol. 63(2), pages 250-294, May.
    2. Kondor, Péter & Babus, Ana, 2013. "Trading and information diffusion in OTC markets," CEPR Discussion Papers 9271, C.E.P.R. Discussion Papers.

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    More about this item

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets

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