The Impact of Arbitrage on Market Liquidity
60 Pages Posted: 20 Jul 2013 Last revised: 25 Jan 2018
Date Written: May 22, 2017
I study deviations from the law of one price in Depositary Receipts using tick-by-tick data from the United States and 22 different home markets from 2001 to 2016. Deviations persist, on average, 12 minutes, and mainly arise because of demand pressure. Exploiting institutional details that create exogenous variation in the impediments to arbitrage within and across days, I show that absolute price deviations predict illiquidity, contemporaneously and in the future. Price deviations mainly predict the inventory costs component of the bid-ask spread. Thus, consistent with recent theory, these findings suggest that arbitrageurs tend to trade against demand pressure and thus enhance market integration and liquidity.
Keywords: arbitrage, liquidity, efficiency, fragmentation, market integration
JEL Classification: G14, G15
Suggested Citation: Suggested Citation