Arbitraging Liquidity

Abstract

This paper shows how arbitrage activity contributes to the convergence of liquidity across markets. Based on simple arbitrage arguments, I show how arbitrageurs' market and limit orders create co-movement across markets of bid prices, ask prices, and bid-ask spreads. Empirically, I document how the intensity of arbitrage activity increases the co-movement of market liquidity between securities linked by arbitrage. I test these hypotheses on Canadian stocks cross-listed in the United States, and then verify the generality of my results by repeating the analysis for the commonality across stocks and corporate bonds linked by capital structure arbitrage.

Keywords: Limits to arbitrage, arbitrage trading, commonality in liquidity, cross-listed stocks

JEL Classification: G12, G14, G15, G23