Arbitrage and Beliefs

Paymon Khorrami and Alexander K. Zentefis

No 8490, CESifo Working Paper Series from CESifo

Abstract: We study a segmented-markets setting in which self-fulfilling volatility can arise. The only requirements are (i) asset price movements redistribute wealth across markets (e.g., equities rise as bonds fall) and (ii) some stabilizing force keeps valuation ratios stationary (e.g., cash flow growth rises when valuations rise). We prove that when self-fulfilling volatility exists, arbitrage opportunities must also exist. Conversely, at times when arbitrage profits exist, asset markets are susceptible to self-fulfilling fluctuations. The tight theoretical connection between price volatility and arbitrage is detectable in currency markets by studying deviations from covered interest parity.

Keywords: limits to arbitrage; segmented markets; volatility; self-fulfilling prices; multiple equilibria; covered interest parity (search for similar items in EconPapers)
JEL-codes: D84 G11 G12 (search for similar items in EconPapers)
Date: 2020
New Economics Papers: this item is included in nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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