Gradual Arbitrage

Abstract

Capital often flows slowly from one market to another in response to buying opportunities. I provide an explanation for this phenomenon by considering arbitrage across two segmented markets when arbitrageurs face illiquidity frictions in the form of price impact costs. I show that illiquidity results in gradual arbitrage: mispricings are generally corrected slowly over time rather than instantaneously. The speed of arbitrage is decreasing in price impact costs and increasing in the level of competition among arbitrageurs. This means arbitrage is slower in more illiquid markets for two reasons: First, there is a direct effect, as illiquidity affects the equilibrium trading strategies for a given level of competition among arbitrageurs (strategic effect). Second, in equilibrium fewer arbitrageurs stand ready to trade between illiquid markets, further slowing down the speed of arbitrage (competition effect). Jointly, these two effects may help explain the observed cross-sectional variation of arbitrage speeds across different asset classes.

Keywords: Illiquidity, Limits to Arbitrage, Strategic Trading, Strategic Arbitrage, Imperfect Competition