The impact of arbitrage on market liquidity

Abstract

I study how arbitrage affects liquidity by analyzing several billion trades in the American Depositary Receipt (ADR) market from 2001 to 2016. Price deviations persist, on average, for 12 min, and mainly arise because of price pressure. Impulse response functions estimated at 1 min intervals indicate that a positive shock to arbitrage—simultaneous trades of the ADR and the home-market share in the opposite direction—decreases deviations and bid-ask spreads. I confirm these findings by exploiting institutional details that create exogenous variation in the impediments to arbitrage across days. Overall, these results suggest that arbitrage decreases price pressure and provides liquidity.