How Riskless is 'Riskless' Arbitrage?

56 Pages Posted: 24 Jan 2010 Last revised: 16 Mar 2014

See all articles by Roman Kozhan

Roman Kozhan

University of Warwick - Warwick Business School

Wing Wah Tham

University of New South Wales (UNSW)

Multiple version iconThere are 2 versions of this paper

Date Written: January 21, 2010

Abstract

In this paper, we challenge the notion that exploiting “riskless” arbitrage is riskless. We show that if rational agents face uncertainty about completing their arbitrage portfolios, then arbitrage is limited even in markets with perfect substitutes and convertibility. We call this phenomenon “execution risk” in arbitrage exploitation. Using a simple model, we demonstrate that this risk arises from the crowding effect of competing arbitrageurs entering the same trade and inflicting negative externalities on each other. We argue that the cost of illiquidity and holding inventory are potential negative externalities. Our empirical results provide evidence that support the relevance of execution risk in arbitrage.

Keywords: execution risk, limit to arbitrage, liquidity, inventory costs

JEL Classification: D50, F31, G10

Suggested Citation

Kozhan, Roman and Tham, Wing Wah, How Riskless is 'Riskless' Arbitrage? (January 21, 2010). Available at SSRN: https://ssrn.com/abstract=1540693 or http://dx.doi.org/10.2139/ssrn.1540693

Roman Kozhan (Contact Author)

University of Warwick - Warwick Business School ( email )

Coventry CV4 7AL
United Kingdom

Wing Wah Tham

University of New South Wales (UNSW)

Kensington
High St
Sydney, NSW 2052
Australia

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