A key factor that prevented financial intermediaries from absorbing shocks – the initial shock and its numerous aftershocks – was their own financial weakness and their limited access to funds. In financial theory terms, at times when arbitrageurs face acute financial constraints, there are so-called “limits to arbitrage”. From this premise, this project develops a theoretical framework to examine the relation between arbitrage capital, both arbitrageurs’ internal capital and the limited capital they are able access externally, and the price properties of different asset markets. In which type of markets will liquidity drop more? Which markets will react more dramatically to a shock to arbitrage capital? What is the effect of arbitrage capital on volatility, and how does this differ across markets depending on their characteristics (size, depth, volatility of fundamentals, etc.)? What is the effect of arbitrage capital on correlations across assets and how does this differ across asset pairs? This project improves the understanding of phenomena of shock amplification and financial contagion and derives new testable implications. The results will shed new light on the activity of financial institutions and intermediaries and on how their activities translate into properties on asset prices and liquidity in these financial markets.
Financially Constrained Arbitrage and Cross-Market Contagion