High-Frequency Arbitrage and Market Illiquidity

Abstract

During times of market stress, asset prices often deviate from their fundamental values due to pervasive market frictions that impede the timely deployment of arbitrage capital. This leads to transitory volatility, a latent factor that can destabilize markets and cause systemic risk. In this paper, I introduce a novel, real-time measure of market-wide illiquidity based on the transitory volatility of the SPY ETF, which tracks the S&P500. Despite being derived from an index, this measure captures commonality in stock-level illiquidity. Moreover, the measure can be computed intra-daily and generates an annual premium of 8.76%, which cannot be explained by existing risk factors, including traditional illiquidity proxies. The methodology is further extended to the Treasury market by proposing a new funding illiquidity measure, allowing for the exploration of liquidity dynamics across markets.

Keywords: Arbitrage, frictions, market illiquidity, continuous-time methods, ETFs, big data, market microstructure, asset pricing

JEL Classification: C14, C22, C58, G12, G14