Dynamic Strategic Arbitrage

Abstract

Many arbitrage strategies are dominated by a few large arbitrageurs who recognize their price impact. I model arbitrageurs as imperfectly competitive intermediaries facilitating risk-sharing between two clienteles of competitive investors. I show that in the presence of market power, i) anticipated supply shocks generate time-series momentum and reversals around the realization of the shocks, ii) negative supply shocks can trigger counterintuitive changes in the sign of liquidity premia, and iii) more risk-averse arbitrageurs may provide more liquidity. Further, a higher trading frequency increases market depth.

Keywords: Strategic arbitrage, liquidity, price impact, limits of arbitrage, anticipated shocks, V-shaped price patterns, time-series momentum and reversal

JEL Classification: G12, G20, L12