Journal of Finance Vol. 64 No. 2 2009

Risk in Dynamic Arbitrage: The Price Effects of Convergence Trading

Péter Kondor^1,2,3,4,5

¹ Central European University · ² British Academy · ³ Frontier Science Foundation-Hellas · ⁴ University College London · ⁵ London School of Economics and Political Science

Abstract

I develop an equilibrium model of convergence trading and its impact on asset prices. Arbitrageurs optimally decide how to allocate their limited capital over time. Their activity reduces price discrepancies, but their activity also generates losses with positive probability, even if the trading opportunity is fundamentally riskless. Moreover, prices of identical assets can diverge even if the constraints faced by arbitrageurs are not binding. Occasionally, total losses are large, making arbitrageurs' returns negatively skewed, consistent with the empirical evidence. The model also predicts comovement of arbitrageurs' expected returns and market liquidity.

DOI

10.1111/j.1540-6261.2009.01445.x

Volume

64

Issue

2

Pages

631-655

Language

en

Sources

bibtex:phds-export.bib openalex crossref

Cite

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