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Toxic Arbitrage

53 Pages Posted: 15 Mar 2014 Last revised: 28 Sep 2016

Thierry Foucault

HEC Paris - Finance Department

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: September 27, 2016

Abstract

Short lived arbitrage opportunities arise when prices adjust with a lag to new information. They are toxic because they expose dealers to the risk of trading at stale quotes. Hence, theory implies that more frequent toxic arbitrage opportunities and a faster arbitrageurs' response to these should impair liquidity. We provide supporting evidence using data on triangular arbitrage. As predicted, illiquidity is higher on days when the fraction of toxic arbitrage opportunities and arbitrageurs' relative speed are higher. Overall, our findings suggest that the price efficiency gain of high frequency arbitrage comes at the cost of increased adverse selection risk.

Keywords: Arbitrage, Liquidity, Adverse Selection, High Frequency Trading

JEL Classification: D50, F31, G10

Suggested Citation

Foucault, Thierry and Kozhan, Roman and Tham, Wing Wah, Toxic Arbitrage (September 27, 2016). HEC Paris Research Paper No. FIN-2014-1040. Available at SSRN: https://ssrn.com/abstract=2409054 or http://dx.doi.org/10.2139/ssrn.2409054

Thierry Foucault (Contact Author)

HEC Paris - Finance Department ( email )

1 rue de la Liberation
Jouy-en-Josas Cedex, 78351
France
(33)139679569 (Phone)
(33)139677085 (Fax)

HOME PAGE: http://thierryfoucault.com/

Roman Kozhan

University of Warwick, Warwick Business School ( email )

Coventry CV4 7AL
United Kingdom

Wing Wah Tham

University of New South Wales (UNSW)

Sydney, NSW 2052
Australia

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