The dynamics of financially constrained arbitrage

Denis Gromb and Dimitri Vayanos

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: We develop a model of financially constrained arbitrage, and use it to study the dynamics of arbitrage capital, liquidity, and asset prices. Arbitrageurs exploit price discrepancies between assets traded in segmented markets, and in doing so provide liquidity to investors. A collateral constraint limits their positions as a function of capital. We show that the dynamics of arbitrage activity are self-correcting: following a shock that depletes arbitrage capital, profitability increases, and this allows capital to be gradually replenished. Spreads increase more and recover faster for more volatile trades, although arbitrageurs cut their positions in these trades the least. When arbitrage capital is more mobile across markets, liquidity in each market generally becomes less volatile, but the reverse may hold for aggregate liquidity because of mobility-induced contagion.

Keywords: arbitrage; liquidity; financial constraints; financial crises. (search for similar items in EconPapers)
JEL-codes: G1 G2 (search for similar items in EconPapers)
Pages: 71 pages
Date: 2015-02-25
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (6)

Downloads: (external link)
http://eprints.lse.ac.uk/62007/ Open access version. (application/pdf)

Related works:
Journal Article: The Dynamics of Financially Constrained Arbitrage (2018)
Working Paper: The dynamics of financially constrained arbitrage (2018)
Working Paper: The dynamics of financially constrained arbitrage (2017)
Working Paper: The Dynamics of Financially Constrained Arbitrage (2015)
Working Paper: The dynamics of financially constrained arbitrage (2015)
Working Paper: The Dynamics of Financially Constrained Arbitrage (2015)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:ehl:lserod:62007

Access Statistics for this paper

More papers in LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library LSE Library Portugal Street London, WC2A 2HD, U.K.. Contact information at EDIRC.
Bibliographic data for series maintained by LSERO Manager ().