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MM-4: Arbitrage and Informed Trading
Why is capital slow moving? Liquidity hysteresis and the dynamics of informed capital
1London Business School; 2Stockholm School of Economics; 3Frankfurt School of Finance & Management, Germany
Will arbitrage capital flow into a market experiencing a shock, mitigating the adverse effect of the shock on price efficiency? Using a stochastic dynamic equilibrium model with privately informed capital-constrained arbitrageurs, we show that informed capital may actually flow out of that market. The remaining informed capital in the market becomes trapped because pricing becomes too inefficient for informed arbitrageurs to want to close out their positions. This mechanism creates endogenous liquidity regimes under which temporary shocks can trigger flight-to-liquidity resulting in ``liquidity hysteresis'' which is a persistent shift in market liquidity and price informativeness.
Limits to Arbitrage in Markets with Stochastic Settlement Latency
1Vienna Graduate School of Finance, Austria; 2WU (Vienna University of Economics and Business), Austria; 3University of Vienna, Austria; 4Center for Financial Studies (CFS), Germany
Distributed ledger technologies confront traders with non-trivial waiting times until the transfer of ownership is accomplished. This settlement process exposes arbitrageurs to price risk and imposes limits to arbitrage. We derive theoretical arbitrage boundaries that increase with expected latency, latency uncertainty, spot volatility, and risk aversion. Using high-frequency data from the Bitcoin network, we estimate arbitrage boundaries due to settlement latency of on average 90 basis points, covering 81% of the observed cross-exchange price differences. We also document cross-exchange flows when price differences exceed our estimated arbitrage boundaries. Settlement latency thus induces non-trivial frictions affecting market efficiency and price formation.
Dynamic Adverse Selection and Liquidity
HEC Paris, France
Does a larger fraction of informed trading generate more illiquidity, as measured by the bid-ask spread? We answer this question in the negative in the context of a dynamic dealer market where the fundamental value follows a random walk, provided we consider the long run (stationary) equilibrium. More informed traders tend to generate more adverse selection and hence larger spreads, but at the same time cause faster learning by the market makers and hence smaller spreads. These two effects offset each other in the long run.
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