Abstract: We investigate the impact of an arbitrageur's activities in an illiquid market, where there is a large distressed trader and a fringe of small traders. Large traders trade strategically considering price impacts of their trades and future uncertainty on market liquidity. Prices are determined endogenously through a dynamic bargaining and trading process. We find that equilibrium strategies for large traders vary with their relative bargaining power and the level of uncertainty with respect to market liquidity. When there is no such uncertainty, the arbitrageur does not trade at all. However, when there is even a slight amount of uncertainty over future liquidity, the arbitrageur may want to sell part of her holdings before the distressed trader. Moreover, her incentive to "front-run" increases with the level of uncertainty. In most cases, the arbitrageur will front-run the distressed trader by selling quickly, and rebuild her position later at a lower price. The distressed trader's optimal response is to liquidate quickly, despite a big price decline. We note, however, that the arbitrageur does not front-run when there is little uncertainty over market liquidity, or when market liquidity improves over time. The distressed seller can then trade quickly without disturbing prices dramatically.
* School of Business, Queen's University