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The Drivers of Cross Market Arbitrage Opportunities: Theory and Evidence for the European Bond Market

  • Perlin, Marcelo
  • Dufour, Alfonso
  • Brooks, Chris

The focus of this paper is on the study of the drivers of a cross market arbitrage profit. Many papers have investigated the risk of trading arbitrage opportunities and the empirical existence of these events at the high frequency level for different markets. But none of the previous work has asked the simple question of how these events are formed in the first place. That is, what are the drivers behind the occurrence of a risk free profit opportunity? In this paper we investigate the theoretical (and empirical) implications of a cross platform arbitrage profit. Following a microstructure model we show that this event is the result of microstructure frictions in trading. We are able to decompose the likelihood of an arbitrage opportunity into three distinct factors: the fixed cost to trade the opportunity, the level of which one of the platforms delays a price update and the impact of the order flow on the quoted prices (inventory and asymmetric information effects). In the second (empirical) part of the paper, we investigate the predictions from the theoretical model for the European Bond market with an event study framework and also using a formal econometric estimation of a probit model. Our main finding is that the results found in the empirical part corroborate strongly with the predictions from the structural model. The event of an arbitrage opportunity has a certain degree of predictability where an optimal ex ante scenario is represented by a low level of spreads on both platforms, a time of the day close to the end of trading hours and a high volume of trade.

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File URL: http://mpra.ub.uni-muenchen.de/23381/1/MPRA_paper_23381.pdf
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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 23381.

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Date of creation: Jun 2010
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Handle: RePEc:pra:mprapa:23381
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  1. Ted Juhl & William Miles & Marc D. Weidenmier, 2006. "Covered Interest Arbitrage: Then versus Now," Economica, London School of Economics and Political Science, vol. 73(290), pages 341-352, 05.
  2. De Long, J. Bradford & Shleifer, Andrei & Summers, Lawrence H. & Waldmann, Robert J., 1990. "Noise Trader Risk in Financial Markets," Scholarly Articles 3725552, Harvard University Department of Economics.
  3. Akram, Q. Farooq & Rime, Dagfinn & Sarno, Lucio, 2008. "Arbitrage in the foreign exchange market: Turning on the microscope," Journal of International Economics, Elsevier, vol. 76(2), pages 237-253, December.
  4. Cheung, Yiu Chung & de Jong, Frank & Rindi, Barbara, 2004. "Trading European Sovereign Bonds: The Microstructure of the MTS Trading Platforms," CEPR Discussion Papers 4285, C.E.P.R. Discussion Papers.
  5. Ted Juhl & William Miles & Marc D. Weidenmier, 2004. "Covered Interest Arbitrage: Then vs. Now," NBER Working Papers 10961, National Bureau of Economic Research, Inc.
  6. A. Craig MacKinlay, Krishna Ramaswamy, 1988. "Index-Futures Arbitrage and the Behavior of Stock Index Futures Prices," Review of Financial Studies, Society for Financial Studies, vol. 1(2), pages 137-158.
  7. Hasbrouck, Joel, 2007. "Empirical Market Microstructure: The Institutions, Economics, and Econometrics of Securities Trading," OUP Catalogue, Oxford University Press, number 9780195301649, March.
  8. Abreu, Dilip & Brunnermeier, Markus K., 2002. "Synchronization risk and delayed arbitrage," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 341-360.
  9. Gagnon, Louis & Andrew Karolyi, G., 2010. "Multi-market trading and arbitrage," Journal of Financial Economics, Elsevier, vol. 97(1), pages 53-80, July.
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