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Equilibrium and Welfare in Markets with Financially Constrained Arbitrageurs

Author

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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.

Suggested Citation

  • Gromb, Denis & Vayanos, Dimitri, 2001. "Equilibrium and Welfare in Markets with Financially Constrained Arbitrageurs," CEPR Discussion Papers 3049, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:3049
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    References listed on IDEAS

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    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    arbitrage; borrowing constraints; collateral; liquidity; welfare;

    JEL classification:

    • D62 - Microeconomics - - Welfare Economics - - - Externalities
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G30 - Financial Economics - - Corporate Finance and Governance - - - General

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