16. November 2005, Péter Kondor: Risk in Dynamic Arbitrage: Price Effects of Convergence Trading
The seminar will be held in Visitor Centre at 3 pm.
Abstract
This paper studies the adverse price effects of convergence trading. We assume two assets with identical cashflows traded in segmented markets. Initially, there is gap between the prices of the assets, because local traders.hedging needs differ. In the absence of arbitrageurs, the gap remains constant until a random period when the difference across local markets disappears. While arbitrageurs.activity reduces the price gap, it also generates potential losses: the price gap widens with positive probability in each period. The size of the gap is determined by the time-varying option value of saving a unit of capital for the next period. In a calibrated example we show that these endogenously created losses alone can explain episodes when arbitrageurs lose most of their capital in a relatively short time.