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Risk in Dynamic Arbitrage: Price Effects of Convergence Trading

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  • Péter Kondor

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Abstract

This paper studies the adverse price effects of convergence trading. I assume two assets with identical cash flows traded in segmented markets. Initially, there is gap between the prices of the assets, because local traders’ face asymmetric temporary shocks. In the absence of arbitrageurs, the gap remains constant until a random time when the difference across local markets disappears. While arbitrageurs’ activity reduces the price gap, it also generates potential losses: the price gap widens with positive probability at each time instant. With the increase of arbitrage capital on the market, the predictability of the dynamics of the gap decreases, and the arbitrage opportunity turns into a risky speculative bet. In a calibrated example we show that the endogenously created losses alone can explain episodes when arbitrageurs lose most of their capital in a relatively short time.

Suggested Citation

  • Péter Kondor, 2006. "Risk in Dynamic Arbitrage: Price Effects of Convergence Trading," MNB Working Papers 2006/6, Magyar Nemzeti Bank (Central Bank of Hungary).
  • Handle: RePEc:mnb:wpaper:2006/6
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    File URL: http://www.mnb.hu/letoltes/wp2006-6.pdf
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    Cited by:

    1. Alex Edmans & Itay Goldstein & Wei Jiang, 2011. "Feedback Effects and the Limits to Arbitrage," NBER Working Papers 17582, National Bureau of Economic Research, Inc.
    2. Dimitri Vayanos & Jiang Wang, 2012. "Market Liquidity - Theory and Empirical Evidence," FMG Discussion Papers dp709, Financial Markets Group.
    3. Kang, Namho & Kondor, Péter & Sadka, Ronnie, 2011. "Idiosyncratic Return Volatility in the Cross-Section of Stocks," CEPR Discussion Papers 8307, C.E.P.R. Discussion Papers.
    4. Tommaso Mancini Griffoli & Angelo Ranaldo, 2010. "Limits to arbitrage during the crisis: funding liquidity constraints and covered interest parity," Working Papers 2010-14, Swiss National Bank.
    5. Kang, Namho & Kondor, Péter & Sadka, Ronnie, 2014. "Do Hedge Funds Reduce Idiosyncratic Risk?," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 49(04), pages 843-877, August.

    More about this item

    Keywords

    Convergence trading; Limits to arbitrage; Liquidity crisis.;

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • D5 - Microeconomics - - General Equilibrium and Disequilibrium

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