The Dynamics of Financially Constrained Arbitrage

Denis Gromb and Dimitri Vayanos

No 10436, CEPR Discussion Papers from Centre for Economic Policy Research

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; Financial constraints; Financial crises; Liquidity (search for similar items in EconPapers)
JEL-codes: D52 D53 G01 G11 G12 G14 G23 (search for similar items in EconPapers)
Date: 2015-02
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Citations: View citations in EconPapers (6)

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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)
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