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Inference, arbitrage, and asset price volatility

  • Adrian, Tobias

Does the presence of arbitrageurs decrease equilibrium asset price volatility? I study an economy with arbitrageurs, informed investors, and noise traders. Arbitrageurs face a trade-off between "inference" and "arbitrage": they would like to buy assets in response to temporary price declines--the arbitrage effect--but sell when prices decline permanently--the inference effect. In equilibrium, the presence of arbitrageurs increases volatility when the inference effect dominates the arbitrage effect. From a technical point of view, the paper offers closed form solutions to a dynamic equilibrium model with asymmetric information and non-Gaussian priors.

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Article provided by Elsevier in its journal Journal of Financial Intermediation.

Volume (Year): 18 (2009)
Issue (Month): 1 (January)
Pages: 49-64

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Handle: RePEc:eee:jfinin:v:18:y:2009:i:1:p:49-64
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/622875

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