The Drivers of Cross Market Arbitrage Opportunities: Theory and Evidence for the European Bond Market

Perlin, Marcelo and Dufour, Alfonso and Brooks, Chris (2010): The Drivers of Cross Market Arbitrage Opportunities: Theory and Evidence for the European Bond Market.

Abstract

The focus of this paper is on the study of the drivers of a cross market arbitrage profit. Many papers have investigated the risk of trading arbitrage opportunities and the empirical existence of these events at the high frequency level for different markets. But none of the previous work has asked the simple question of how these events are formed in the first place. That is, what are the drivers behind the occurrence of a risk free profit opportunity? In this paper we investigate the theoretical (and empirical) implications of a cross platform arbitrage profit. Following a microstructure model we show that this event is the result of microstructure frictions in trading. We are able to decompose the likelihood of an arbitrage opportunity into three distinct factors: the fixed cost to trade the opportunity, the level of which one of the platforms delays a price update and the impact of the order flow on the quoted prices (inventory and asymmetric information effects). In the second (empirical) part of the paper, we investigate the predictions from the theoretical model for the European Bond market with an event study framework and also using a formal econometric estimation of a probit model. Our main finding is that the results found in the empirical part corroborate strongly with the predictions from the structural model. The event of an arbitrage opportunity has a certain degree of predictability where an optimal ex ante scenario is represented by a low level of spreads on both platforms, a time of the day close to the end of trading hours and a high volume of trade.

• Item Type: MPRA Paper
• Language: English
• Keywords: arbitrage opportunities; negative spreads; market microstructure; market efficiency
• Subjects: D - Microeconomics > D5 - General Equilibrium and Disequilibrium; G - Financial Economics > G0 - General; G - Financial Economics > G2 - Financial Institutions and Services > G20 - General

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