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Limits of Arbitrage

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Author Info

  • Denis Gromb
  • Dimitri Vayanos

    ()
    (INSEAD, Fontainebleau, 77305, France
    Center for Economic and Policy Research (CEPR), London EC1V 0DG, United Kingdom
    London School of Economics, London WC2A 2AE, United Kingdom
    National Bureau of Economic Research (NBER), Cambridge, Massachusetts 02138)

Abstract

We survey theoretical developments in the literature on the limits of arbitrage. This literature investigates how costs faced by arbitrageurs can prevent them from eliminating mispricings and providing liquidity to other investors. Research in this area is currently evolving into a broader agenda, emphasizing the role of financial institutions and agency frictions for asset prices. This research has the potential to explain so-called market anomalies and inform welfare and policy debates about asset markets. We begin with examples of demand shocks that generate mispricings, arguing that they can stem from behavioral or from institutional considerations. We next survey, and nest within a simple model, the following costs faced by arbitrageurs: (a) risk, both fundamental and nonfundamental; (b) short-selling costs; (c) leverage and margin constraints; and (d) constraints on equity capital. We finally discuss implications for welfare and policy and suggest directions for future research.

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File URL: http://www.annualreviews.org/doi/abs/10.1146/annurev-financial-073009-104107
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Bibliographic Info

Article provided by Annual Reviews in its journal Annual Review of Financial Economics.

Volume (Year): 2 (2010)
Issue (Month): 1 (December)
Pages: 251-275

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Handle: RePEc:anr:refeco:v:2:y:2010:p:251-275

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Related research

Keywords: market anomalies; liquidity; financial constraints; financial institutions;

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Cited by:
  1. Eric Belasco & Michael Finke & David Nanigian, 2012. "The impact of passive investing on corporate valuations," Managerial Finance, Emerald Group Publishing, vol. 38(11), pages 1067-1084, November.
  2. ap Gwilym, Owain & Wang, Qingwei & Hasan, Iftekhar & Xie, Ru, 2013. "In search of concepts: The effects of speculative demand on returns and volume," Research Discussion Papers 10/2013, Bank of Finland.
  3. Jason Allen & James Chapman & Federico Echenique & Matthew Shum, 2012. "Efficiency and Bargaining Power in the Interbank Loan Market," Working Papers 12-29, Bank of Canada.
  4. Umar M. Mustapha, 2012. "The Role of Speculation in the Determination of Energy Prices," International Journal of Energy Economics and Policy, Econjournals, vol. 2(4), pages 279-291.

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