Risk in Dynamic Arbitrage: Price Effects of Convergence Trading
AbstractThis 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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Bibliographic InfoPaper provided by Magyar Nemzeti Bank (the central bank of Hungary) in its series MNB Working Papers with number 2006/6.
Length: 39 pages
Date of creation: 2006
Date of revision:
Convergence trading; Limits to arbitrage; Liquidity crisis.;
Find related papers by JEL classification:
- G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
- G20 - Financial Economics - - Financial Institutions and Services - - - General
- D5 - Microeconomics - - General Equilibrium and Disequilibrium
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