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Time-varying Arbitrage Efficacy
( Jingzhi Chen ),( Yongcheol Shin ),( Huamao Wang ) 한국금융연구원 2022 금융연구 working paper Vol.2022 No.10
Arbitrageurs utilise leverage to capitalise on arbitrage opportunities. If an adverse shock is large enough to make leverage constraint binding, arbitrage activities become ineffective as they are forced to deleverage. As a main contribution we propose a novel measure of time-varying arbitrage efficacy that can identify the periods when arbitrage activities become ineffective. The arbitrage efficacy is shown to be a significant predictor of the financial market volatility and instability, more prominent during ineffective arbitrage periods that coincide with market turmoil. This suggests that the arbitrage efficacy can serve as an indicator of the marketwide downside risk.