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Risk in Dynamic Arbitrage: Price Effects of Convergence Trading

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  • Péter Kondor

    ()

Abstract

This paper studies the adverse price effects of convergence trading. I assume two assets with identical cash flows traded in segmented markets. Initially, there is gap between the prices of the assets, because local traders’ face asymmetric temporary shocks. In the absence of arbitrageurs, the gap remains constant until a random time when the difference across local markets disappears. While arbitrageurs’ activity reduces the price gap, it also generates potential losses: the price gap widens with positive probability at each time instant. With the increase of arbitrage capital on the market, the predictability of the dynamics of the gap decreases, and the arbitrage opportunity turns into a risky speculative bet. In a calibrated example we show that the endogenously created losses alone can explain episodes when arbitrageurs lose most of their capital in a relatively short time.

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File URL: http://english.mnb.hu/Root/Dokumentumtar/MNB/Kiadvanyok/mnbhu_mnbfuzetek/mnbhu_wp2006_6/wp2006_6.pdf
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Bibliographic Info

Paper provided by Magyar Nemzeti Bank (the central bank of Hungary) in its series MNB Working Papers with number 2006/6.

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Length: 39 pages
Date of creation: 2006
Date of revision:
Handle: RePEc:mnb:wpaper:2006/6

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Related research

Keywords: Convergence trading; Limits to arbitrage; Liquidity crisis.;

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Cited by:
  1. Alex Edmans & Itay Goldstein & Wei Jiang, 2011. "Feedback Effects and the Limits to Arbitrage," NBER Working Papers 17582, National Bureau of Economic Research, Inc.
  2. Guillaume Plantin & Igor Makarov, 2012. "Deliberate Limits to Arbitrage," 2012 Meeting Papers 831, Society for Economic Dynamics.
  3. Namho Kang & Peter Kondor & Ronnie Sadka, 2012. "Do Hedge Funds Reduce Idiosyncratic Risk?," CEU Working Papers 2012_15, Department of Economics, Central European University, revised 04 Oct 2012.
  4. Dimitri Vayanos & Jiang Wang, 2012. "Market Liquidity - Theory and Empirical Evidence," FMG Discussion Papers dp709, Financial Markets Group.
  5. Tommaso Mancini Griffoli & Angelo Ranaldo, 2010. "Limits to arbitrage during the crisis: funding liquidity constraints and covered interest parity," Working Papers 2010-14, Swiss National Bank.
  6. Kang, Namho & Kondor, Péter & Sadka, Ronnie, 2011. "Idiosyncratic Return Volatility in the Cross-Section of Stocks," CEPR Discussion Papers 8307, C.E.P.R. Discussion Papers.

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