Dynamic Strategic Arbitrage

Abstract:     
Real-world arbitrage often involves a limited number of large financial intermediaries (e.g. dealers, hedge funds) with price impact. I study a multi-period model of imperfectly competitive arbitrage, in which supply shocks generate price differences between two identical assets traded in segmented markets. Arbitrageurs seeking to exploit these price differences split up their orders to limit their price impact. I show that this mechanism and specific supply shock patterns can explain the empirical evidence that i) identical assets can trade at different prices, ii) these price differences revert slowly over time, as if capital was slow-moving, iii) the sign of price differences can switch over time, iv) market depth is time-varying. The model also offers new testable predictions, in particular that the market structure is a driver of arbitrage speed and changes in market depth, and shows that strategic arbitrageurs do not necessarily offset increases in arbitrage risk.

Number of Pages in PDF File: 47

Keywords: Strategic arbitrage, liquidity, limits of arbitrage

JEL Classification: G12, G20, L12

working papers series