Arbitrageurs help stock markets function better Monday, 14 December 2015
When a company’s stocks are traded in more than one market, sometimes there’s a price differential between the different venues – but it’s an undesirable situation for any business to have stock priced higher in New York than in London. Potential sellers in London start to wonder if they’ll get a fair price, and there’s a risk that trading will come to a halt. Arbitrageurs specialise in trading against these price differentials by buying low in one market and selling high in another. In his upcoming PhD defence, Dominik Rösch from Rotterdam School of Management, Erasmus University (RSM) demonstrates that arbitrageurs contribute to a more integrated market and lead to higher liquidity.
Interest in a company’s stock will always vary between markets, Rösch explains. Localised media coverage or market changes mean that demand for a particular company’s stock can suddenly surge in one market, or the price could reach its low point in another. In a perfect world, stock markets would react instantly and prices would quickly level out between stock markets, but a price difference that can be exploited by arbitragers originates when stock prices follow localised demand.
Stock markets work imperfectly in real life, so price differences can be enough to entice arbitrageurs to trade. After arbitrage deals, stock price rises equalise. This makes information about a particular stock more credible, which in turn leads to more trading. By trading, arbitrageurs also inject liquidity into that particular market, which stimulates general trading there.
Sometimes there’s a difference in stock prices between markets not because of difference in demand, but because of imperfect information. For example, a local liquidity provider might be slow to update its stock prices so a particular stock might be over- or under-valued in that particular market. If the arbitrageurs start trading against that price differential, then sellers lose out on profit because they aren’t aware of the stock’s fundamental value. Here, the total liquidity decreases because of arbitrageurs. This ‘toxic’ variant of arbitrage is bad for stock markets which rely on a steady supply of liquidity.
Helpful or harmful?
How do the positive effects of arbitrageurs correcting market imbalances and creating equal information weigh up against the negative effects of toxic arbitrage? Rösch’s results show that 70 per cent of arbitrages are caused by demand shocks. As a result, the positive effects of arbitrage outstrip the negatives. On the whole, more arbitrageur activity leads to a better-integrated market and a higher liquidity for traders, Rösch concludes.
Dominik Rösch will defend his dissertation in the Senate Hall at Erasmus University Rotterdam on Friday, 18 December 2015 at 11:30. His supervisor is Prof. M.A. van Dijk. Other members of the Doctoral Committee are Dr D.G.J. Bongaerts (RSM), Prof. J.J.A.G. Driessen (Tilburg University), and Prof. A.J. Menkveld (VU Amsterdam).
Rotterdam School of Management, Erasmus University (RSM) is a leading European business school, and ranked among the top three for research. RSM provides ground-breaking research and education furthering excellence in all aspects of management and is based in the international port city of Rotterdam – a vital nexus of business, logistics and trade. RSM’s primary focus is on developing business leaders with international careers who carry their innovative mindset into a sustainable future thanks to a first-class range of bachelor, master, MBA, PhD and executive programmes. RSM also has offices in Chengdu, China, and Taipei, Taiwan. www.rsm.nl
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Photo: CC-BY Rafael Matsunaga