Hysteresis in Price Efficiency and the Economics of Slow Moving Capital

76 Pages Posted: 4 Jun 2018 Last revised: 5 Jun 2020

See all articles by James Dow

James Dow

London Business School - Institute of Finance and Accounting

Jungsuk Han

Swedish House of Finance

Francesco Sangiorgi

Frankfurt School of Finance & Management gemeinnützige GmbH

Date Written: June 4, 2020

Abstract

Will arbitrage capital flow into markets experiencing shocks, mitigating adverse effects on price efficiency? Not necessarily. In a dynamic model with privately informed capital-constrained arbitrageurs, price efficiency plays a dual role, determining both the profitability of new arbitrage and the ability to close existing positions profitably. An adverse shock to efficiency lengthens arbitrage duration, effectively reducing the amount of arbitrage capital available for new positions. If this falls below a critical mass, arbitrage capital flows out, amplifying the impact on price efficiency. This creates endogenous regimes: temporary shocks can trigger “hysteresis,” a persistent shift in price efficiency.

Keywords: rational expectations, price efficiency, history dependence, slow-moving capital, regime shift, informed trading

JEL Classification: G12, G14, D82, D83, D84

Suggested Citation

Dow, James and Han, Jungsuk and Sangiorgi, Francesco, Hysteresis in Price Efficiency and the Economics of Slow Moving Capital (June 4, 2020). Swedish House of Finance Research Paper No. 18-12, Available at SSRN: https://ssrn.com/abstract=3181409 or http://dx.doi.org/10.2139/ssrn.3181409

James Dow

London Business School - Institute of Finance and Accounting ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom
+44 20 7262 5050 (Phone)
+44 20 7724 3317 (Fax)

Jungsuk Han (Contact Author)

Swedish House of Finance ( email )

Drottninggatan 98
111 60 Stockholm
Sweden

Francesco Sangiorgi

Frankfurt School of Finance & Management gemeinnützige GmbH ( email )

Adickesallee 34
Frankfurt am Main, 60322
Germany

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