Risk in Dynamic Arbitrage: Price Effects of Convergence Trading

Péter Kondor

No 2006/6, MNB Working Papers from Magyar Nemzeti Bank (Central Bank of Hungary)

Abstract: This paper studies the adverse price effects of convergence trading. I assume two assets with identical cash flows traded in segmented markets. Initially, there is gap between the prices of the assets, because local traders’ face asymmetric temporary shocks. In the absence of arbitrageurs, the gap remains constant until a random time when the difference across local markets disappears. While arbitrageurs’ activity reduces the price gap, it also generates potential losses: the price gap widens with positive probability at each time instant. With the increase of arbitrage capital on the market, the predictability of the dynamics of the gap decreases, and the arbitrage opportunity turns into a risky speculative bet. In a calibrated example we show that the endogenously created losses alone can explain episodes when arbitrageurs lose most of their capital in a relatively short time.

Keywords: Convergence trading; Limits to arbitrage; Liquidity crisis. (search for similar items in EconPapers)
JEL-codes: D5 G10 G20 (search for similar items in EconPapers)
Pages: 39 pages
Date: 2006
New Economics Papers: this item is included in nep-fin
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Citations: View citations in EconPapers (8)

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Related works:
Journal Article: Risk in Dynamic Arbitrage: The Price Effects of Convergence Trading (2009)
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Persistent link: https://EconPapers.repec.org/RePEc:mnb:wpaper:2006/6

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