Job Market Paper
The Impact of Volatility on Arbitrageurs' Participation (draft available upon request)
with C. Cañon Salazar
Models with limits to arbitrage, increasingly used in international finance and macroeconomics, often rely on static participation by homogeneous arbitrageurs. Instead, this paper documents the existence of two distinct types of arbitrageurs---hedge funds and dealer banks---and shows that volatility affects the composition of arbitrageurs trading across different markets. We test the predictions of a two-arbitrageurs preferred-habitat model by leveraging detailed data on the quasi-universe of trades by UK financial institutions. Exploiting quasi-natural variation from one of the largest volatility shocks in UK bond history---the 2022 gilts market meltdown---we show that hedge funds traded only nominal bonds, and within these, concentrated in shorter-term bonds whereas dealer banks traded inflation-linked and long-term nominal bonds. We attribute this specialization to the relative fragility of hedge funds' funding and to banks' access to the lender of last resort, which facilitates intermediation in long-term bonds. Finally, we show that the relationship between hedge funds' participation and volatility extends beyond large shocks. Our evidence points to a new channel that explains fragility in the market for long-term bonds.
with C. Cañon Salazar
Models with limits to arbitrage, increasingly used in international finance and macroeconomics, often rely on static participation by homogeneous arbitrageurs. Instead, this paper documents the existence of two distinct types of arbitrageurs---hedge funds and dealer banks---and shows that volatility affects the composition of arbitrageurs trading across different markets. We test the predictions of a two-arbitrageurs preferred-habitat model by leveraging detailed data on the quasi-universe of trades by UK financial institutions. Exploiting quasi-natural variation from one of the largest volatility shocks in UK bond history---the 2022 gilts market meltdown---we show that hedge funds traded only nominal bonds, and within these, concentrated in shorter-term bonds whereas dealer banks traded inflation-linked and long-term nominal bonds. We attribute this specialization to the relative fragility of hedge funds' funding and to banks' access to the lender of last resort, which facilitates intermediation in long-term bonds. Finally, we show that the relationship between hedge funds' participation and volatility extends beyond large shocks. Our evidence points to a new channel that explains fragility in the market for long-term bonds.
Working Papers
The Liquidity State Dependence of Monetary Policy Transmission
with R. Guimaraes, G. Pinter and J.C. Wijnandts
We show that monetary policy shocks move long-term government bond yields only when market liquidity is high and arbitrageurs are well capitalized. This liquidity state dependence operates entirely through real term premia, not expectations. Using novel transaction-level data on the US Treasury market, we find that arbitrageurs trade about 40% more duration during FOMC meetings in high-liquidity periods. We propose ways of enriching standard term-structure models to rationalize our evidence that constraints on arbitrage capital suppress transmission. The results introduce new empirical moments for theories of limits to arbitrage, and underscore the role of liquidity conditions in shaping the effectiveness of conventional monetary policy.
with R. Guimaraes, G. Pinter and J.C. Wijnandts
We show that monetary policy shocks move long-term government bond yields only when market liquidity is high and arbitrageurs are well capitalized. This liquidity state dependence operates entirely through real term premia, not expectations. Using novel transaction-level data on the US Treasury market, we find that arbitrageurs trade about 40% more duration during FOMC meetings in high-liquidity periods. We propose ways of enriching standard term-structure models to rationalize our evidence that constraints on arbitrage capital suppress transmission. The results introduce new empirical moments for theories of limits to arbitrage, and underscore the role of liquidity conditions in shaping the effectiveness of conventional monetary policy.
