Risk in Dynamic Arbitrage: The Price Effects of Convergence Trading

Authors

  • PÉTER KONDOR

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    • Péter Kondor is with Central European University. This paper is a substantially revised version of Chapter 3 of my PhD thesis at the London School of Economics; it was finalized at the Graduate School of Business of the University of Chicago. I am grateful for the guidance of Hyun Shin and Dimitri Vayanos and the helpful comments from Péter Benczúr, Margaret Bray, Markus Brunnermeier, John Cochrane, Doug Diamond, Darrell Duffie, Zsuzsi Elek, Antoine Faure-Grimaud, Miklós Koren, Arvind Krishnamurthy, Pete Kyle, John Moore, Lubos Pástor, Andrei Shleifer, Jeremy Stein, Jakub Steiner, Gergely Ujhelyi, Pietro Veronesi, Wei Xiong, Campbell R. Harvey (the editor), an associate editor, an anonymus referee, and seminar participants at Berkeley, Central Bank of Hungary (MNB), Central European University, Chicago, Columbia, Duke, Gerzensee, Harvard, HEC Paris, INSEAD, London Business School, London School of Economics, MIT, New York University, Princeton, Stanford, University College London, Wharton, Yale, and the 2005 European Winter Meeting of the Econometric Society in Istanbul. I also would like to extend thanks to Patricia Egner and Monica Crabtree-Reusser for editorial assistance, and gratefully acknowledge the EU grant “Archimedes Prize” (HPAW-CT-2002-80054), the GAM Award, and financial support from the MNB.


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.

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