The Impact of Arbitrage on Market Liquidity

Theory predicts that arbitrage improves financial market liquidity when arbitrage opportunities arise as a result of temporary demand shocks and worsens liquidity when arbitrage opportunities arise as a result of differences in information. In this paper, I study the impact of arbitrage in Depositary Receipts (DRs) on market liquidity, using tick-by-tick data from the U.S. and five different home markets from 1996 to 2013. My analysis suggests that around 70% of the arbitrage opportunities in DRs arise as a result of demand shocks. Consistent with theory, I then show that an increase in arbitrage activity is associated with a reduction in market order imbalance and an improvement in liquidity. My results are robust to different proxies for arbitrage activity, different methodologies, and to instrumental variable tests. Overall, these findings indicate that arbitrageurs tend to trade against market order imbalance and thus enhance market integration and liquidity. 

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