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Risk in Dynamic Arbitrage: The Price Effects of Convergence Trading
Author(s) -
KONDOR PÉTER
Publication year - 2009
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/j.1540-6261.2009.01445.x
Subject(s) - arbitrage , economics , asset (computer security) , financial economics , convergence (economics) , market liquidity , monetary economics , limits to arbitrage , risk arbitrage , index arbitrage , econometrics , capital asset pricing model , arbitrage pricing theory , macroeconomics , computer security , computer science
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.