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Dynamic Strategic Arbitrage

47 Pages Posted: 14 Jan 2012 Last revised: 16 Nov 2012

Vincent Fardeau

National Research University Higher School of Economics - International College of Economics and Finance

Multiple version iconThere are 2 versions of this paper

Date Written: June 5, 2012

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 di fferences 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 di fferent 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 off ers 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 o ffset increases in arbitrage risk.

Keywords: Strategic arbitrage, liquidity, limits of arbitrage

JEL Classification: G12, G20, L12

Suggested Citation

Fardeau, Vincent, Dynamic Strategic Arbitrage (June 5, 2012). AFA 2013 San Diego Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1984896 or http://dx.doi.org/10.2139/ssrn.1984896

Vincent Fardeau (Contact Author)

National Research University Higher School of Economics - International College of Economics and Finance ( email )

Pokrovski Bulvar 11, Korpus Zh, Office 715
Moscow, 109028
Russia

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