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Financially constrained arbitrage and cross-market contagion


  • Dimitri Vayanos

    (London School of Economics)

  • Denis Gromb



We propose a continuous time infinite horizon equilibrium model of financial markets in which arbitrageurs have multiple valuable investment opportunities but face financial constraints. The investment opportunities, heterogeneous along different dimensions, are provided by pairs of similar assets trading at different prices in segmented markets. By exploiting these opportunities, arbitrageurs alleviate the segmentation of markets, providing liquidity to other investors by intermediating their trades. We characterize the arbitrageurs' optimal investment policy, and derive implications for market liquidity and asset prices. We show that liquidity is smallest, volatility is largest, correlations between asset pairs with uncorrelated fundamentals are largest, and correlations between asset pairs with highly correlated fundamentals are smallest for intermediate levels of arbitrageur wealth.

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  • Dimitri Vayanos & Denis Gromb, 2012. "Financially constrained arbitrage and cross-market contagion," 2012 Meeting Papers 112, Society for Economic Dynamics.
  • Handle: RePEc:red:sed012:112

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    1. repec:cup:apsrev:v:104:y:2010:i:03:p:519-542_00 is not listed on IDEAS
    2. Timothy Besley & Stephen Coate, 1997. "An Economic Model of Representative Democracy," The Quarterly Journal of Economics, Oxford University Press, vol. 112(1), pages 85-114.
    3. Martin J. Osborne & Al Slivinski, 1996. "A Model of Political Competition with Citizen-Candidates," The Quarterly Journal of Economics, Oxford University Press, vol. 111(1), pages 65-96.
    4. Georgy Egorov & Konstantin Sonin, 2013. "A Political Theory of Populism," The Quarterly Journal of Economics, Oxford University Press, vol. 128(2), pages 771-805.
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