March 28, 2024 (NO COMMENTS)

Game theory and real-world data point to a different understanding of how arbitrage in markets works

Game theory and real-world data point to a different understanding of how arbitrage in markets works When academics at the London Business School conducted a study into a multi-million-dollar arbitrage trade known as the “dividend play” last year, they were surprised to find arbitrageurs left half the potential profit on the table. What was more: at various times, only single trading firms seemed to be trying to make money. The findings, published in the Journal of Finance in December last year, confound standard models of arbitrage, which assume trading firms will chase all available chances for a near-riskless profit, starting with the most lucrative. In a follow-up working paper, the team draws on game theory to create a model to explain what might be going on. What they conclude might change how practitioners think about how markets work. In real life, “it’s like traders are not stepping on each other’s toes”, says Anna Pavlova, a professor of finance at London Business School, who led the research. The researchers propose a new model that hinges on what game theorists call a tacit collusion equilibrium – a form of co-operation among market participants that requires no explicit agreement and can arise naturally from traders seeking to maximise long-term profit. The academics acknowledge in the paper they have only indirect evidence of this happening. But the research findings serve as a “cautionary tale”, they suggest, about the potential presence of such effects in broader markets.
Copyright Infopro Digital Limited. All rights reserved.

You may share this content using our article tools. Copying this content is for the sole use of the Authorised User (named subscriber), as outlined in our terms and conditions – https://www.infopro-insight.com/terms-conditions/insight-subscriptions/