The paper studies incentives and trading decisions of an arbitrageur who can take concentrated bets in an illiquid market and who cares about interim as well as long-term performance. By scaling up his position and using price impact, the arbitrageur can prop up the value of his position, helping him weather periods of low valuation and successfully complete the arbitrage. But that approach also can trap him into building an outsized arbitrage position, which can cause persistent mispricing in the market, even in the presence of other arbitrageurs, and lead to large losses to investors.
Financial Markets Group Discussion Papers DP 820
Paul Woolley Centre Discussion Papers No 71