The Dynamics of Financially Constrained Arbitrage

Abstract

We develop a model in which financially constrained arbitrageurs exploit price discrepancies across segmented markets. We show that the dynamics of arbitrage capital are self‐correcting: following a shock that depletes capital, returns increase, which allows capital to be gradually replenished. Spreads increase more for trades with volatile fundamentals or more time to convergence. Arbitrageurs cut their positions more in those trades, except when volatility concerns the hedgeable component. Financial constraints yield a positive cross‐sectional relationship between spreads/returns and betas with respect to arbitrage capital. Diversification of arbitrageurs across markets induces contagion, but generally lowers arbitrageurs' risk and price volatility.

Liquidity Risk and the Dynamics of Arbitrage Capital

“…InGromb and Vayanos (2018), arbitrage spreads are positively related to the spreads' sensitivity to arbitrageur wealth because both characteristics are positively related to cash flow volatility and convergence horizon. 5Isaenko (2015) studies a related model in which long-term traders maximize CARA utility and face transaction costs.…”

“…In Gromb and Vayanos (), arbitrage spreads are positively related to the spreads' sensitivity to arbitrageur wealth because both characteristics are positively related to cash flow volatility and convergence horizon.…”

The Pecking Order of Segmentation and Liquidity-Injection Policies in a Model of Contagious Crises

“…The computation is done through various combinations of the partial derivatives (28) to (31), to account for governments' coordination:any change in policy in country A is matched, simultaneously and symmetrically, by country B. Hence,…”

“…To know when the G constraint binds, we calculate country A's incentive to inject liquidity unilaterally. Since θ * = θ T A + θ T B , the incentive of an uncoordinated government to inject liquidity is given by adding up derivatives (29) and (31):…”

“…The authors find that "arbitrage activity benefits all investors ... [albeit] competitive arbitrageurs could ... fail to take a socially optimal level of risk". Gromb and Vayanos (2018) generalize the framework in several important dimensions and characterize the dynamics of arbitrage capital towards a steady state. Caballero and Simsek (2017) present a three-period model with a continuum of countries.…”