Arbitrage and Beliefs

49 Pages Posted: 18 Aug 2020

See all articles by Paymon Khorrami

Paymon Khorrami

Imperial College Business School

Alexander Zentefis

Yale School of Management

Date Written: 2020

Abstract

We study a segmented-markets setting in which self-fulfilling volatility can arise. The only requirements are (i) asset price movements redistribute wealth across markets (e.g., equities rise as bonds fall) and (ii) some stabilizing force keeps valuation ratios stationary (e.g., cash flow growth rises when valuations rise). We prove that when self-fulfilling volatility exists, arbitrage opportunities must also exist. Conversely, at times when arbitrage profits exist, asset markets are susceptible to self-fulfilling fluctuations. The tight theoretical connection between price volatility and arbitrage is detectable in currency markets by studying deviations from covered interest parity.

Keywords: limits to arbitrage, segmented markets, volatility, self-fulfilling prices, multiple equilibria, covered interest parity

JEL Classification: D840, G110, G120

Suggested Citation

Khorrami, Paymon and Zentefis, Alexander, Arbitrage and Beliefs (2020). CESifo Working Paper No. 8490, Available at SSRN: https://ssrn.com/abstract=3676096 or http://dx.doi.org/10.2139/ssrn.3676096

Paymon Khorrami (Contact Author)

Imperial College Business School ( email )

South Kensington Campus
Exhibition Road
London SW7 2AZ, SW7 2AZ
United Kingdom

HOME PAGE: http://www.paymonkhorrami.com

Alexander Zentefis

Yale School of Management ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States

HOME PAGE: http://som.yale.edu/alexander-zentefis

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