Fardeau, Vincent
(2011)
Essays in financial economics.
PhD thesis, London School of Economics and Political Science.
Abstract
In this thesis, I study the effects of market power and financial constraints on arbitrage,
liquidity provision, financial stability and welfare. In Chapter 1, I consider a dynamic model
of imperfectly competitive arbitrage with time-varying supply. The model can explain the
well-documented empirical features that (quasi)-identical assets can trade at significantly
different prices; these price differences vanish slowly over time, resulting in apparently slow-
moving capital; the price differences can invert over time; market depth is time-varying. I
also show that entry does not necessarily correct these effects, although the mere threat of
entry may improve liquidity.
In Chapter 2, I introduce in the model the realistic feature that trading requires cap-
ital and assume that arbitrageurs' positions must be fully collateralized, which rules out
default. I compare liquidity provision, asset prices and welfare in the monopoly case to the
perfect competition case studied by Gromb and Vayanos (2002). I show that relative to
the competitive case, the monopoly is less efficient but also less capital-intensive, as rents
captured over time allow her to build up capital. Consequently, when capital is scarce,
financially-constrained competitive arbitrageurs may provide less liquidity at later stages
than an unconstrained monopoly. In some cases, this increases aggregate welfare but with-
out being Pareto-improving. I discuss implications for market-making via a specialist.
In Chapter 3, I assume that some arbitrageurs have deeper pockets than others and allow
for default. The capital-rich arbitrageurs (predators) either provide liquidity to other mar-
ket participants (competitive hedgers) or engage in predatory trading against a financially-
constrained peer (prey). In this strategy, predators depress the price of the asset to trigger
a margin call on the prey's position and gain from her subsequent firesales. I show that
the hedgers' reactions to the possibility of predation can make predatory trading cheaper,
reducing the prey's staying power. In anticipation of the prey's firesales, hedgers may run
on the asset, strengthening and to some extent substituting to the predators' price pressure.
Further, their reaction leads to a reduction in the prey's price impact, which decreases her
already limited ability to support the price and avoid a margin call. Predatory trading is
likely to occur when hedgers are sufficiently risk-averse or the asset sufficiently risky.
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