Execution Risk in High‐Frequency Arbitrage

Execution Risk in High‐Frequency Arbitrage

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Article ID: iaor20127210
Volume: 58
Issue: 11
Start Page Number: 2131
End Page Number: 2149
Publication Date: Nov 2012
Journal: Management Science
Authors: ,
Keywords: risk
Abstract:

In this paper, we investigate the role of execution risk in high‐frequency trading through arbitrage strategies. We show that if rational agents face uncertainty about completing their arbitrage portfolios, then arbitrage is limited even in markets with perfect substitutes and convertibility. Using a simple model, we demonstrate that this risk arises from the crowding effect of competing arbitrageurs entering the same trade and inflicting negative externalities on each other. Our empirical results provide evidence that support the relevance of execution risk in high‐frequency arbitrage.

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