How Riskless is 'Riskless' Arbitrage?

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