Arbitrage Chains

James Dow and Gary Gorton

No 4314, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: In efficient markets the price should reflect the arrival of private information. The mechanism by which this is accomplished is arbitrage. A privately informed trader will engage in costly arbitrage, that is, trade on his knowledge that the price of an asset is different from the fundamental value if: (1) his order does not move the price immediately to reflect the information; (2) he can hold the asset until the date when the information is reflected in the price. We study a general equilibrium model in which all agents optimize. In each period, there may be a trader with a limited horizon who has private information about a distant event. Whether he acts on his information, and whether subsequent informed traders act, is shown to depend on the possibility of a sequence or chain of future informed traders spanning the event date. An arbitrageur who receives good news will buy only if it is likely that, at the end of his trading horizon, a subsequent arbitrageur's buying will have pushed up the expected price. We show that limited trading horizons result in inefficient prices because informed traders do not act on their information until the event date is sufficiently close.

JEL-codes: G12 (search for similar items in EconPapers)
Date: 1993-04
Note: AP
References: View references in EconPapers View complete reference list from CitEc
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Published as Dow, James and Gary Gorton. "Arbitrage Chains," Journal of Finance, 1994, v49(3), 819-849.

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Related works:
Journal Article: Arbitrage Chains (1994)
Working Paper: Arbitrage Chains (1993)
Working Paper: Arbitrage Chains
Working Paper: Arbitrage Chains
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