Distressed Sales and Financial Arbitrageurs: Front-Running in Illiquid Markets

79 Pages Posted: 14 Feb 2009

See all articles by Dan Liang

Dan Liang

School of Economics, Shanghai University of Finance and Economics

Multiple version iconThere are 2 versions of this paper

Date Written: June 1, 2007

Abstract

We investigate the impact of an arbitrageur's activities in an illiquid market, where there is a large distressed trader and a fringe of small traders. Large traders trade strategically considering price impacts of their trades and future uncertainty on market liquidity. Prices are determined endogenously through a dynamic bar-gaining and trading process. We find that equilibrium strategies for large traders vary with their relative bargaining power and the level of uncertainty with respect to market liquidity. When there is no such uncertainty, the arbitrageur does not trade at all. However, when there is even a slight amount of uncertainty over future liquidity, the arbitrageur may want to sell part of her holdings before the distressed trader. Moreover, her incentive to "front-run" increases with the level of uncertainty. In most cases, the arbitrageur will front-run the distressed trader by selling quickly, and rebuild her position later at a lower price. The distressed trader's optimal response is to liquidate quickly, despite a big price decline. We note, however, that the arbitrageur does not front-run when there is little uncertainty over market liquidity, or when market liquidity improves over time. The distressed seller can then trade quickly without disturbing prices dramatically.

Keywords: Front-running, Illiquidity, Distressed sales, Financial arbitrageurs

JEL Classification: G12

Suggested Citation

Liang, Dan, Distressed Sales and Financial Arbitrageurs: Front-Running in Illiquid Markets (June 1, 2007). Available at SSRN: https://ssrn.com/abstract=1343086 or http://dx.doi.org/10.2139/ssrn.1343086

Dan Liang (Contact Author)

School of Economics, Shanghai University of Finance and Economics ( email )

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