The Dynamics of Financially Constrained Arbitrage

69 Pages Posted: 2 Mar 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)

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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.

Suggested Citation

Gromb, Denis and Vayanos, Dimitri, The Dynamics of Financially Constrained Arbitrage (February 2015). NBER Working Paper No. w20968. Available at SSRN: https://ssrn.com/abstract=2572106

Denis Gromb (Contact Author)

HEC Paris

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France

Dimitri Vayanos

London School of Economics ( email )

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Center for Economic Policy Research (CEPR)

London
United States

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

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