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Arbitrage with Holding Costs: A Utility-Based Approach

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  • Tuckman, Bruce
  • Vila, Jean-Luc
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    Abstract

    Unit time costs, or holding costs, are incurred in many arbitrage contexts. Examples include losing the use of short sale proceeds and lending funds at below market rates in reverse repurchase agreements. This paper analyzes the investment problem of a risk-averse arbitrageur who faces holding costs. The model allows prices to deviate from "fundamental" values without allowing for riskless arbitrage opportunities. After characterizing an arbitrageur's optimal strategy, the model is examined in the context of the Treasury market. The analysis reveals that holding costs are an important friction in this market and that they can significantly affect arbitrageur behavior. Copyright 1992 by American Finance Association.

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    Bibliographic Info

    Article provided by American Finance Association in its journal Journal of Finance.

    Volume (Year): 47 (1992)
    Issue (Month): 4 (September)
    Pages: 1283-302

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    Handle: RePEc:bla:jfinan:v:47:y:1992:i:4:p:1283-302

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    Cited by:
    1. Dimitri Vayanos & Jiang Wang, 2012. "Market Liquidity — Theory and Empirical Evidence," NBER Working Papers 18251, National Bureau of Economic Research, Inc.
    2. Vila, Jean-Luc & Zariphopoulou, Thaleia, 1997. "Optimal Consumption and Portfolio Choice with Borrowing Constraints," Journal of Economic Theory, Elsevier, vol. 77(2), pages 402-431, December.
    3. Chris Kenyon & Andrew Green, 2013. "Regulatory-Compliant Derivatives Pricing is Not Risk-Neutral," Papers 1311.0118, arXiv.org, revised Aug 2014.
    4. Denis Gromb & Dimitri Vayanos, 2002. "Equilibrium and welfare in markets with financially constrained arbitrageurs," LSE Research Online Documents on Economics 448, London School of Economics and Political Science, LSE Library.
    5. Jouini, Elyes & Kallal, Hedi, 2001. "Efficient Trading Strategies in the Presence of Market Frictions," Review of Financial Studies, Society for Financial Studies, vol. 14(2), pages 343-69.
    6. David M. Schizer & Michael R. Powers & Martin Shubik, 2003. "Market Bubbles and Wasteful Avoidance: Tax and Regulatory Constraints on Short Sales," Yale School of Management Working Papers, Yale School of Management ysm356, Yale School of Management.
    7. Attari, Mukarram & Mello, Antonio S., 2006. "Financially constrained arbitrage in illiquid markets," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 30(12), pages 2793-2822, December.
    8. Laurent Deville & Fabrice Riva, 2007. "Liquidity and Arbitrage in Options Markets: A SurvivalAnalysis Approach," Post-Print halshs-00162221, HAL.
    9. Pontiff, Jeffrey, 2006. "Costly arbitrage and the myth of idiosyncratic risk," Journal of Accounting and Economics, Elsevier, Elsevier, vol. 42(1-2), pages 35-52, October.
    10. Liu, Jun & Longstaff, Francis A, 2000. "Losing Money on Arbitrages: Optimal Dynamic Portfolio Choice in Markets with Arbitrage Opportunities," University of California at Los Angeles, Anderson Graduate School of Management qt48k8f97f, Anderson Graduate School of Management, UCLA.

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