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The dynamics of financially constrained arbitrage

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  • Gromb, Denis
  • Vayanos, Dimitri

Abstract

We develop a model in which financially constrained arbitrageurs exploit price discrepancies across segmented markets. We show that the dynamics of arbitrage capital are self-correcting: following a shock that depletes capital, returns increase, and this allows capital to be gradually replenished. Spreads increase more for trades with volatile fundamentals or more time to convergence. Arbitrageurs cut their positions more in those trades, except when volatility concerns the hedgeable component. Financial constraints yield a positive cross-sectional relationship between spreads/returns and betas with respect to arbitrage capital. Diversification of arbitrageurs across markets induces contagion, but generally lowers arbitrageurs’ risk and price volatility.

Suggested Citation

  • Gromb, Denis & Vayanos, Dimitri, 2018. "The dynamics of financially constrained arbitrage," LSE Research Online Documents on Economics 84081, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:84081
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    More about this item

    Keywords

    arbitrage; financial constraints; market segmentation; liquidity; contagion.;
    All these keywords.

    JEL classification:

    • F3 - International Economics - - International Finance
    • G3 - Financial Economics - - Corporate Finance and Governance

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