Segmented Arbitrage

Abstract

We use arbitrage activity in equity, fixed income, and foreign exchange markets to characterize the frictions and constraints facing intermediaries. The average pairwise correlation between the twenty-nine arbitrage spreads that we study is 22%. These low correlations are inconsistent with models in which an integrated intermediary sector faces a single constraint and sets all prices. We show that at least two types of segmentation drive arbitrage dynamics. First, funding is segmented --- certain trades rely on specific funding sources so arbitrage spreads are sensitive to localized funding shocks. Second, balance sheets are segmented --- intermediaries specialize in certain arbitrages so arbitrage spreads are sensitive to idiosyncratic balance sheet shocks. Our results suggest specialization on both the asset and liability sides of intermediary balance sheets is important for understanding their role in capital markets.

Keywords: arbitrage; segmentation; intermediary-based asset pricing

JEL Classification: G12, G2