Price Manipulation and Quasi Arbitrage

By Gur Huberman And Werner Stanzl

Summer 2013 Radhika Nangia

Introduction
"Assuming no arbitrage is compelling because the presence of arbitrage is inconsistent with equilibrium when preferences increase with quantity. More fundamentally, the presence of arbitrage is inconsistent with the existence of an optimal portfolio strategy for any competitive agent who prefers more to less, because there is no limit to the scale at which an individual would want to hold the arbitrage position. Therefore, in principle, absence of arbitrage follows from individual rationality of a single agent. One appeal of results based on the absence of arbitrage is the intuition that few rational agents are needed to bid away arbitrage opportunities, even in the presence of a sea of agents driven by `animal spirits'." (P.H. Dybvig and S.A.Ross, 1987)

Model
Single asset traded over periods over (0,1]. The asset can be bought or sold at times (equally spaced) , 1 , where 1/. is exogenously fixed. In each period , the initial price is , . The trader trades , on his own. Price Impact , (Immediate effect): , = , + , (, ). Price Update , (Permanent effect): +1, = , + , , .

Model
Competitive Liquidity Providers Given: A set of price impact and price update functions as a consequence of asymmetric information , inventory costs , etc. Not dependent on the equilibrium of market Price change due to public news , is revealed the beginning of period Trades from the trading crowd : , , and , are i.i.d ,independent and have 0 expected values.

Model
Price dynamics

, = 1, + 1, 1, + 1, + , .
, = , + , (, + , ). Fixed transaction costs for trades is > 0 Conditions for pure arbitrage : Traders know the prices they can trade at any time Investments can be scaled without affecting prices. Both these assumptions are relaxed!

Model
Round trip is a sequence of trades ,
=1 ,
=1

if

= 0 . Hence, actual no. of trades are ( 0, ) .

Profit of round trip : 0,

, ,
=1

(( 0, )).

Risk Neutral Price Manipulation : Round trip trade 0, with expected value 0, > 0. An unbounded (risk neutral) Price manipulation: A sequence 0, 0, of round trip trades { }=1 with lim =
0, Quasi Arbitrage : An unbounded price manipulation { }=1 0, 0, that satisfies lim /Std[ ] = .

Model
Market Viability: Depends on whether optimal demand exists! Traders optimal demand : arg max0, (( 0, )) . A market is weakly viable if the optimal demand of the trader exists . A market is strongly viable if the optimal demand exists uniquely and is zero ! Limited price manipulation possible in a weakly viable market Weak viability No quasi arbitrage !

Model
Expected Price-Impact function:, () [, ( + , )] Expected Price-Impact function: , () [, ( + , )]

, 0 , 0 0 , 0 , 0 0
Market Classification :
: Prices have first moments and is fixed i.e. Price Manipulation 1 :Prices have first moments and , () , () for nonnegative i.e. Unbounded price manipulation 2 :Prices have both first and second moments and variances do not grow faster than linearly as i.e. Quasi arbitrage

Absence of Price Manipulation

CLAIMS The Expected price update function must be symmetric i.e. , = , () .This yields 0, > 0 for sufficiently smaller . is continuous everywhere except possibly at the origin i.e. lim = , 0 when lim = .

is linear since > 1 or < 1 induces price manipulation! U is linear. Using = . =0.

Proposition 1
Suppose that any trade size is allowed for the trader and that either : i. 1, = 0 = 1 or ii. The crowds trades are normally distributed.

Then , the absence of price manipulation in requires U to be linear with nonnegative slope L(R)-a.e. The linearity of U with nonnegative slope is also implied by each, the absence of unbounded price manipulation in 1 and the absence of quasi arbitrage in 2 .

Theorem 1
Defn : A function : is quasi linear if it has the representation = + on , 0, ()-a.e., where the - Borel Measurable function : satisfies , , + , = 0 Theorem The absence of price manipulation in requires U to be quasi linear. The quasi-linearity of U is also a consequence of each , the absence of unbounded price manipulation in 1 , and the absence of quasi arbitrage in 2 .

Proposition 2
If either no price manipulation or no quasi arbitrage holds and if fixed costs c(k) are proportional to , < 1 then the following two conditions hold

i. ii.

> <

for 0,

> <

0 and 0.

Sufficient condition for NoPM-NoQA

Proposition 3: Let U be linear with nonnegative slope,L(R) a.e. and assume the crowds trades have a normal distribution. If
2

= fornonnegative , then (NoPM)(NoQA) are all satisfied. Proposition 4: Suppose (i) satisfies the condition given in Proposition 3 and (ii)the crowds trades are normally distributed .Then , linearity of U ( with nonnegative slope L(R) a.e.) is equivalent to the absence of price manipulation in .It is also equivalent to NoUM and NoQA.

Corollary
Corollary Assume that the conditions (i) and (ii) in proposition 4 are met. Then, the absence of quasi arbitrage in market 2 is characterized by the strong viability of 2 .If the trader is risk neutral , the strong viability of market 1 is equivalent to the absence of unbounded price manipulation in 1 .

Time dependent price impact

Liquidity ( first derivative of price impact and price update function) is varying across time .

, = 1, + 1, 1, + 1, + , . , = , + , (, + , ). For sequences {, } =1 and {, }=1 , where , = , 0

The price update slope can have any sign but the price impact slope should only be positive! Unbounded price manipulation can be implemented in finitely many trades.

Theorem 2
Fixing an arbitrary . For all sufficiently large prices 0, , no price manipulation in ( ) is characterized by the positive semidefiniteness of the matrix 22, 2, 2, 2, 2, 23, 3, 3, 2, 3, 24, 4, 2, 3, 4, 2, For any given price update sequence there exists a priceimpact sequence that preserves the absence of price manipulation. Non linear ,time dependent price update functions may lead to a chaotic shapes but not necessarily price manipulation.

Kyle Model
Black(1995) conjectured that the Kyle Model allowed for arbitrage opportunities for uninformed agents if they pretend to be informed. Kyle showed that for the case of normally and i.i.d trading volume of the crowd, this game has a unique linear equilibrium where price evolves according to

, = 1, + , , + ,
, is endogenously determined
Theorem 2 is applicable . For any , Kyles slopes are almost constant and hence price manipulation is infeasible. Hence , Kyles equilibrium is strongly viable.

Proposition 5
Suppose the price update functions {, } =1 are symmetric , i.e., , = , 0, 0, and monotone in the sense that , 1, 0.Then , given the price dynamics , = 1, + , , + , + , , normally
distributed , s and the condition that lim (,), 1 exists , the absence of unbounded price manipulation in 1 implies that the expected price update functions converge pointwise to a linear function on any interval , 1 , 0 < <1/2, as .More formally , for any > 0 and R there exists an index 0 such that for 0 , < , with 1 , 0.

Some other key points

For a multiple asset case : we can incorporate cross price impact functions

All results in theorem 1, and propositions 1 and 4 regarding the absence of price manipulation in are literally true for the multi asset case. Only we impose a restriction of no temporary price impacts. Gain-Loss Ratio : [ + ]/[ ], where is the payoff of a zero cost portfolio!

Thank You