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Equilibrium and Welfare in Markets with Financially Constrained Arbitrageurs

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  • Gromb, Denis
  • Vayanos, Dimitri

Abstract

We propose a multi-period model in which competitive arbitrageurs exploit discrepancies between the prices of two identical risky assets, traded in segmented markets. Arbitrageurs need to collateralize separately their positions in each asset, and this implies a financial constraint limiting positions as a function of wealth. We derive an equilibrium and study its welfare properties. Allowing arbitrageurs to trade makes all investors better off. Arbitrageurs' positions may not be Pareto optimal, however, in the sense that a change in these positions may make all investors better off. We characterize conditions under which arbitrageurs take excessive or too little risk.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3049.

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Date of creation: Nov 2001
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Handle: RePEc:cpr:ceprdp:3049

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Keywords: arbitrage; borrowing constraints; collateral; liquidity; welfare;

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  1. Grossman, Sanford J. & Vila, Jean-Luc, 1992. "Optimal Dynamic Trading with Leverage Constraints," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 27(02), pages 151-168, June.
  2. Kogan, Leonid & Uppal, Raman, 2002. "Risk Aversion and Optimal Portfolio Policies in Partial and General Equilibrium Economies," CEPR Discussion Papers 3306, C.E.P.R. Discussion Papers.
  3. James Dow & Gary Gorton, . "Arbitrage Chains," Rodney L. White Center for Financial Research Working Papers 06-93, Wharton School Rodney L. White Center for Financial Research.
  4. Basak, Suleyman & Cuoco, Domenico, 1998. "An Equilibrium Model with Restricted Stock Market Participation," Review of Financial Studies, Society for Financial Studies, vol. 11(2), pages 309-41.
  5. Shleifer, Andrei & Vishny, Robert W, 1997. " The Limits of Arbitrage," Journal of Finance, American Finance Association, vol. 52(1), pages 35-55, March.
  6. Basak, Suleyman & Croitoru, Benjamin, 2000. "Equilibrium Mispricing in a Capital Market with Portfolio Constraints," Review of Financial Studies, Society for Financial Studies, vol. 13(3), pages 715-48.
  7. Admati, Anat R & Pfleiderer, Paul, 1990. "Direct and Indirect Sale of Information," Econometrica, Econometric Society, vol. 58(4), pages 901-28, July.
  8. Duffie Darrell & Rahi Rohit, 1995. "Financial Market Innovation and Security Design: An Introduction," Journal of Economic Theory, Elsevier, vol. 65(1), pages 1-42, February.
  9. Cuoco, Domenico, 1997. "Optimal Consumption and Equilibrium Prices with Portfolio Constraints and Stochastic Income," Journal of Economic Theory, Elsevier, vol. 72(1), pages 33-73, January.
  10. John Geanakoplos, 2001. "Liquidity, Default and Crashes: Endogenous Contracts in General Equilibrium," Cowles Foundation Discussion Papers 1316, Cowles Foundation for Research in Economics, Yale University.
  11. Tuckman, Bruce & Vila, Jean-Luc, 1993. "Holding Costs and Equilibrium Arbitrage," University of California at Los Angeles, Anderson Graduate School of Management qt41b480fn, Anderson Graduate School of Management, UCLA.
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