The Dynamics of Financially Constrained Arbitrage

70 Pages Posted: 24 Feb 2015

See all articles by Denis Gromb

Denis Gromb

HEC Paris

Dimitri Vayanos

London School of Economics; Center for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: February 2015

Abstract

We develop a model of financially constrained arbitrage, and use it to study the dynamics of arbitrage capital, liquidity, and asset prices. Arbitrageurs exploit price discrepancies between assets traded in segmented markets, and in doing so provide liquidity to investors. A collateral constraint limits their positions as a function of capital. We show that the dynamics of arbitrage activity are self-correcting: following a shock that depletes arbitrage capital, profitability increases, and this allows capital to be gradually replenished. Spreads increase more and recover faster for more volatile trades, although arbitrageurs cut their positions in these trades the least. When arbitrage capital is more mobile across markets, liquidity in each market generally becomes less volatile, but the reverse may hold for aggregate liquidity because of mobility-induced contagion.

Keywords: arbitrage, financial constraints, financial crises, liquidity

JEL Classification: D52, D53, G01, G11, G12, G14, G23

Suggested Citation

Gromb, Denis and Vayanos, Dimitri, The Dynamics of Financially Constrained Arbitrage (February 2015). CEPR Discussion Paper No. DP10436. Available at SSRN: https://ssrn.com/abstract=2569265

Denis Gromb (Contact Author)

HEC Paris

1 rue de la Liberation
Jouy-en-Josas Cedex, 78351
France

Dimitri Vayanos

London School of Economics ( email )

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Houghton Street
London WC2A 2AE
United Kingdom
+44 (0)20 7955 6382 (Phone)
+44 (0)20 7955 7420 (Fax)

Center for Economic Policy Research (CEPR)

London
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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