In efficient markets the price should reflect the arrival of private information. The mechanism by which this is accomplished is arbitrage. A privately informed trader will engage in costly arbitrage, that is, trade on his knowledge that the price of an asset is different from the fundamental value if: (1) his order does not move the price immediately to reflect the information; (2) he can hold the asset until the date when the information is reflected in the price. We study a general equilibrium model in which all agents optimize. In each period, there may be a trader with a limited horizon who has private information about a distant event. Whether he acts on his information, and whether subsequent informed traders act, is shown to depend on the possibility of a sequence or chain of future informed traders spanning the event date. An arbitrageur who receives good news will buy only if it is likely that, at the end of his trading horizon, a subsequent arbitrageurs’ buying will have pushed up the expected price. We show that limited trading horizons result in inefficient prices because informed traders do not act on their information until the event date is sufficiently close.
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Article
Dow, James & Gorton, Gary, 1994.
" Arbitrage Chains,"
Journal of Finance,
American Finance Association, vol. 49(3), pages 819-49, July.
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Paper
James Dow & Gary Gorton, 1993.
"Arbitrage Chains,"
NBER Working Papers
4314, National Bureau of Economic Research, Inc.
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James Dow & Gary Gorton, 1993.
"Arbitrage Chains,"
CEPR Financial Markets Paper
0035, European Science Foundation Network in Financial Markets, c/o C.E.P.R, 53--56 Great Sutton Street, London EC1V 0DG.
References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
De Long, J Bradford & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1990.
"Noise Trader Risk in Financial Markets,"
Journal of Political Economy,
University of Chicago Press, vol. 98(4), pages 703-38, August.
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