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Inference, arbitrage, and asset price volatility

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  • Tobias Adrian

Abstract

This paper models the impact of arbitrageurs on stock prices when arbitrageurs are uncertain about the drift of the dividend process of a risky asset. Under perfect information, the presence of risk-neutral arbitrageurs unambiguously reduces the volatility of asset returns. When arbitrageurs are uncertain about the drift of the dividend process, they condition their investment strategy on the observation of dividends and trading volume. In such a setting, the presence of arbitrageurs can lead to an increase in the equilibrium volatility of asset returns. The arbitrageurs' inference problem gives rise to rich dynamics of asset prices and investment strategies: the optimal trading strategy of arbitrageurs can be upward sloping in prices, the response of prices to news can be nonlinear, and minor news can have large effects. These results are driven by the arbitrageurs' inability to perfectly distinguish temporary from permanent shocks. Arbitrageurs would like to sell assets in response to temporary price increases and buy assets in response to permanent price increases.

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Bibliographic Info

Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 187.

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Date of creation: 2004
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Handle: RePEc:fip:fednsr:187

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Keywords: Asset pricing ; Arbitrage ; Stock - Prices ; Uncertainty ; Risk;

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Cited by:
  1. Contreras, Mauricio & Montalva, Rodrigo & Pellicer, Rely & Villena, Marcelo, 2010. "Dynamic option pricing with endogenous stochastic arbitrage," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 389(17), pages 3552-3564.
  2. Tobias Adrian & Michael J. Fleming, 2005. "What financing data reveal about dealer leverage," Current Issues in Economics and Finance, Federal Reserve Bank of New York, vol. 11(Mar).

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