Toxic Arbitrage

64 Pages Posted: 2 Jun 2014

See all articles by Thierry Foucault

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: April 2014

Abstract

High frequency arbitrage opportunities sometimes arise when the price of one asset follows, with a lag, changes in the value of another related asset due to information arrival. These opportunities are toxic because they expose liquidity suppliers to the risk of being picked off by arbitrageurs. Hence, more frequent toxic arbitrage opportunities and a faster arbitrageurs' response to these opportunities impair liquidity. We find support for these predictions using high frequency triangular arbitrage opportunities in the FX market. In our sample, a 1% increase in the likelihood that a toxic arbitrage terminates with an arbitrageur's trade (rather than a quote update) raises bid-ask spreads by about 4%.

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

JEL Classification: D50, F31, G10

Suggested Citation

Foucault, Thierry and Kozhan, Roman and Tham, Wing Wah, Toxic Arbitrage (April 2014). CEPR Discussion Paper No. DP9925. Available at SSRN: https://ssrn.com/abstract=2444948

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)

Kensington
High St
Sydney, NSW 2052
Australia

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