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The Drivers of Cross Market Arbitrage Opportunities: Theory and Evidence for the European Bond Market

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  • Perlin, Marcelo
  • Dufour, Alfonso
  • Brooks, Chris

Abstract

The focus of this paper is on the study of the drivers of a cross market arbitrage profit. Many papers have investigated the risk of trading arbitrage opportunities and the empirical existence of these events at the high frequency level for different markets. But none of the previous work has asked the simple question of how these events are formed in the first place. That is, what are the drivers behind the occurrence of a risk free profit opportunity? In this paper we investigate the theoretical (and empirical) implications of a cross platform arbitrage profit. Following a microstructure model we show that this event is the result of microstructure frictions in trading. We are able to decompose the likelihood of an arbitrage opportunity into three distinct factors: the fixed cost to trade the opportunity, the level of which one of the platforms delays a price update and the impact of the order flow on the quoted prices (inventory and asymmetric information effects). In the second (empirical) part of the paper, we investigate the predictions from the theoretical model for the European Bond market with an event study framework and also using a formal econometric estimation of a probit model. Our main finding is that the results found in the empirical part corroborate strongly with the predictions from the structural model. The event of an arbitrage opportunity has a certain degree of predictability where an optimal ex ante scenario is represented by a low level of spreads on both platforms, a time of the day close to the end of trading hours and a high volume of trade.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 23381.

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Date of creation: Jun 2010
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Handle: RePEc:pra:mprapa:23381

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Related research

Keywords: arbitrage opportunities; negative spreads; market microstructure; market efficiency;

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References

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  1. Ted Juhl & William Miles & Marc D. Weidenmier, 2006. "Covered Interest Arbitrage: Then versus Now," Economica, London School of Economics and Political Science, vol. 73(290), pages 341-352, 05.
  2. Cheung, Yiu Chung & de Jong, Frank & Rindi, Barbara, 2005. "Trading European sovereign bonds: the microstructure of the MTS trading platforms," Working Paper Series 0432, European Central Bank.
  3. J. Bradford De Long & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, . "Noise Trader Risk in Financial Markets," J. Bradford De Long's Working Papers _124, University of California at Berkeley, Economics Department.
  4. Akram, Q. Farooq & Rime, Dagfinn & Sarno, Lucio, 2006. "Arbitrage in the Foreign Exchange Market: Turning on the Microscope," SIFR Research Report Series 42, Institute for Financial Research.
  5. Hasbrouck, Joel, 2007. "Empirical Market Microstructure: The Institutions, Economics, and Econometrics of Securities Trading," OUP Catalogue, Oxford University Press, number 9780195301649.
  6. Ted Juhl & William Miles & Marc D. Weidenmier, 2004. "Covered Interest Arbitrage: Then vs. Now," NBER Working Papers 10961, National Bureau of Economic Research, Inc.
  7. Gagnon, Louis & Karolyi, G. Andrew, 2004. "Multi-market Trading and Arbitrage," Working Paper Series 2004-9, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
  8. Abreu, Dilip & Brunnermeier, Markus K., 2002. "Synchronization risk and delayed arbitrage," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 341-360.
  9. A. Craig MacKinlay, Krishna Ramaswamy, 1988. "Index-Futures Arbitrage and the Behavior of Stock Index Futures Prices," Review of Financial Studies, Society for Financial Studies, vol. 1(2), pages 137-158.
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