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Financially constrained arbitrage and cross-market contagion

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  • Dimitri Vayanos

    (London School of Economics)

  • Denis Gromb

    (INSEAD)

Abstract

We propose a continuous time infinite horizon equilibrium model of financial markets in which arbitrageurs have multiple valuable investment opportunities but face financial constraints. The investment opportunities, heterogeneous along different dimensions, are provided by pairs of similar assets trading at different prices in segmented markets. By exploiting these opportunities, arbitrageurs alleviate the segmentation of markets, providing liquidity to other investors by intermediating their trades. We characterize the arbitrageurs' optimal investment policy, and derive implications for market liquidity and asset prices. We show that liquidity is smallest, volatility is largest, correlations between asset pairs with uncorrelated fundamentals are largest, and correlations between asset pairs with highly correlated fundamentals are smallest for intermediate levels of arbitrageur wealth.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 112.

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Date of creation: 2012
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Handle: RePEc:red:sed012:112

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Cited by:
  1. Anand, Amber & Irvine, Paul & Puckett, Andy & Venkataraman, Kumar, 2013. "Institutional trading and stock resiliency: Evidence from the 2007–2009 financial crisis," Journal of Financial Economics, Elsevier, vol. 108(3), pages 773-797.

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