Arbitrage Chains

39 Pages Posted: 28 Dec 2006 Last revised: 30 Dec 2006

See all articles by James Dow

James Dow

London Business School - Institute of Finance and Accounting

Gary B. Gorton

Yale School of Management; National Bureau of Economic Research (NBER); Yale University - Yale Program on Financial Stability

Multiple version iconThere are 2 versions of this paper

Date Written: April 1993

Abstract

In efficient markets the price should reflect the arrival of private information. The mechanism by which this is accomplished is arbitrage. A privately informed trader will engage in costly arbitrage, that is, trade on his knowledge that the price of an asset is different from the fundamental value if: (1) his order does not move the price immediately to reflect the information; (2) he can hold the asset until the date when the information is reflected in the price. We study a general equilibrium model in which all agents optimize. In each period, there may be a trader with a limited horizon who has private information about a distant event. Whether he acts on his information, and whether subsequent informed traders act, is shown to depend on the possibility of a sequence or chain of future informed traders spanning the event date. An arbitrageur who receives good news will buy only if it is likely that, at the end of his trading horizon, a subsequent arbitrageur's buying will have pushed up the expected price. We show that limited trading horizons result in inefficient prices because informed traders do not act on their information until the event date is sufficiently close.

Suggested Citation

Dow, James and Gorton, Gary B., Arbitrage Chains (April 1993). NBER Working Paper No. w4314. Available at SSRN: https://ssrn.com/abstract=478730

James Dow (Contact Author)

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

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Gary B. Gorton

Yale School of Management ( email )

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HOME PAGE: http://mba.yale.edu/faculty/profiles/gorton.shtml

National Bureau of Economic Research (NBER)

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Yale University - Yale Program on Financial Stability

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United States

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