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Inference, arbitrage, and asset price volatility

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  • Adrian, Tobias

Abstract

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.

Suggested Citation

  • Adrian, Tobias, 2009. "Inference, arbitrage, and asset price volatility," Journal of Financial Intermediation, Elsevier, vol. 18(1), pages 49-64, January.
  • Handle: RePEc:eee:jfinin:v:18:y:2009:i:1:p:49-64
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    Cited by:

    1. Contreras, Mauricio & Montalva, Rodrigo & Pellicer, Rely & Villena, Marcelo, 2010. "Dynamic option pricing with endogenous stochastic arbitrage," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 389(17), pages 3552-3564.
    2. Tobias Adrian & Michael J. Fleming, 2005. "What financing data reveal about dealer leverage," Current Issues in Economics and Finance, Federal Reserve Bank of New York, vol. 11(Mar).

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