Statistical Arbitrage and Risk Contagion

Contagions among financial intermediaries have been shown to play a significant role in the propagation of financial distress. Contagions among assets, however, have received less attention. This paper examines the role of statistical arbitrage in connecting assets and the resulting impact on market stability. We find that statistical arbitrage stabilises markets in normal periods, however, it acts as a mechanism for risk contagion when extreme events occur. A relatively low density of statistical arbitrage improves the resilience of the system, relative to the case when none is present, while a high level results in increased susceptibility to shocks. The impact of statistical arbitrage on wealth is also considered.