The Dynamics of Financially Constrained Arbitrage

77 Pages Posted: 23 Aug 2017

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)

Date Written: August 14, 2017

Abstract

We develop a model in which financially constrained arbitrageurs exploit price discrepancies across segmented markets. We show that the dynamics of arbitrage capital are self-correcting: following a shock that depletes capital, returns increase, and this allows capital to be gradually replenished. Spreads increase more for trades with volatile fundamentals or more time to convergence. Arbitrageurs cut their positions more in those trades, except when volatility concerns the hedgeable component. Financial constraints yield a positive cross-sectional relationship between spreads/returns and betas with respect to arbitrage capital. Diversification of arbitrageurs across markets induces contagion, but generally lowers arbitrageurs' risk and price volatility.

Keywords: Arbitrage, financial constraints, market segmentation, liquidity, contagion

JEL Classification: G11, G12, G14, G15, G23

Suggested Citation

Gromb, Denis and Vayanos, Dimitri, The Dynamics of Financially Constrained Arbitrage (August 14, 2017). Journal of Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3023633

Denis Gromb

HEC Paris

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Dimitri Vayanos (Contact Author)

London School of Economics ( email )

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Center for Economic Policy Research (CEPR)

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National Bureau of Economic Research (NBER)

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