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Does Arbitrage Flatten Demand Curves for Stocks?

  • Jeffrey Wurgler

    (New York University)

  • Ekaterina Zhuravskaya

    (Centre for Economic and Financial Research (Moscow) and Centre for Economic Policy Research)

In textbook theory, demand curves for stocks are kept flat by riskless arbitrage between perfect substitutes. In reality, however, individual stocks do not have perfect substitutes. We develop a simple model of demand curves for stocks in which the risk inherent in arbitrage between imperfect substitutes deters risk-averse arbitrageurs from flattening demand curves. Consistent with the model, stocks without close substitutes experience higher price jumps upon inclusion into the S&P 500 Index. The results suggest that arbitrage is weaker and mispricing is likely to be more frequent and more severe among stocks without close substitutes.

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Article provided by University of Chicago Press in its journal Journal of Business.

Volume (Year): 75 (2002)
Issue (Month): 4 (October)
Pages: 583-608

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Handle: RePEc:ucp:jnlbus:v:75:y:2002:i:4:p:583-608
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