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.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
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
This paper has been announced in the following NEP Reports:
You can help add them by filling out this form.
CitEc Project, subscribe to its RSS feed for this item.
- Alex Edmans & Itay Goldstein & Wei Jiang, 2011. "Feedback Effects and the Limits to Arbitrage," NBER Working Papers 17582, National Bureau of Economic Research, Inc.
- 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.
- Mancini Griffoli, Tommaso & Ranaldo, Angelo, 2012.
"Limits to Arbitrage during the Crisis: Finding Liquidity Constraints and Covered Interest Parity,"
Working Papers on Finance
1212, University of St. Gallen, School of Finance.
- 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.
- Guillaume Plantin & Igor Makarov, 2012. "Deliberate Limits to Arbitrage," 2012 Meeting Papers 831, Society for Economic Dynamics.
- Dimitri Vayanos & Jiang Wang, 2012.
"Market Liquidity - Theory and Empirical Evidence,"
FMG Discussion Papers
dp709, Financial Markets Group.
- 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.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Johanna Jeney).
If references are entirely missing, you can add them using this form.