Toxic Arbitrage
64 Pages Posted: 2 Jun 2014
There are 2 versions of this paper
Toxic Arbitrage
Date Written: April 2014
Abstract
High frequency arbitrage opportunities sometimes arise when the price of one asset follows, with a lag, changes in the value of another related asset due to information arrival. These opportunities are toxic because they expose liquidity suppliers to the risk of being picked off by arbitrageurs. Hence, more frequent toxic arbitrage opportunities and a faster arbitrageurs' response to these opportunities impair liquidity. We find support for these predictions using high frequency triangular arbitrage opportunities in the FX market. In our sample, a 1% increase in the likelihood that a toxic arbitrage terminates with an arbitrageur's trade (rather than a quote update) raises bid-ask spreads by about 4%.
Keywords: Adverse Selection, Arbitrage, High Frequency Trading, Liquidity
JEL Classification: D50, F31, G10
Suggested Citation: Suggested Citation
Thierry Foucault (Contact Author)
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