Strategic Arbitrage in Segmented Markets

Department: Finance

Speaker: Anna Pavlova (LBS)

Room: T020

Abstract

We propose a model in which arbitrageurs act strategically in markets with entry costs.
In a repeated game, arbitrageurs choose to specialize in some markets, which leads to
the highest combined profits. We present evidence consistent with our theory from the
options market, in which suboptimally unexercised options create arbitrage opportu-
nities for intermediaries. Using transaction-level data, we identify the corresponding
arbitrage trades. Consistent with the model, only 57% of these opportunities attract
entry by arbitrageurs. Of those that do, 50% attract only one arbitrageur. Finally, our
paper details how market participants circumvent a regulation devised to curtail this
arbitrage strategy.