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Equilibrium and Welfare in Markets with Financially Constrained Arbitrageurs

  • Gromb, Denis
  • Vayanos, Dimitri

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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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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  1. Nobuhiro Kiyotaki, 1998. "Credit and Business Cycles," The Japanese Economic Review, Japanese Economic Association, vol. 49(1), pages 18-35, 03.
  2. Leonid Kogan & Raman Uppal, . "Risk Aversion and Optimal Portfolio Policies in Partial and General Equilibrium Economies," Rodney L. White Center for Financial Research Working Papers 13-00, Wharton School Rodney L. White Center for Financial Research.
  3. Aiyagari, S.R. & Gertler, M., 1998. ""Overreaction" of Asset Prices in General Equilibrium," Working Papers 98-25, C.V. Starr Center for Applied Economics, New York University.
  4. Franklin R. Edward, 1999. "Hedge Funds and the Collapse of Long-Term Capital Management," Journal of Economic Perspectives, American Economic Association, vol. 13(2), pages 189-210, Spring.
  5. 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.
  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. Bengt Holmström, 2001. "LAPM: A Liquidity-Based Asset Pricing Model," Journal of Finance, American Finance Association, vol. 56(5), pages 1837-1867, October.
  8. Xiong, Wei, 2001. "Convergence trading with wealth effects: an amplification mechanism in financial markets," Journal of Financial Economics, Elsevier, vol. 62(2), pages 247-292, November.
  9. Froot, Kenneth A & Scharfstein, David S & Stein, Jeremy C, 1993. " Risk Management: Coordinating Corporate Investment and Financing Policies," Journal of Finance, American Finance Association, vol. 48(5), pages 1629-58, December.
  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. James Dow & Gary Gorton, 1993. "Arbitrage Chains," CEPR Financial Markets Paper 0035, European Science Foundation Network in Financial Markets, c/o C.E.P.R, 77 Bastwick Street, London EC1V 3PZ..
  12. Jean-Pierre Zigrand, 1999. "Arbitrage and Endogenous Market Integration," FMG Discussion Papers dp319, Financial Markets Group.
  13. Shleifer, Andrei & Vishny, Robert W, 1992. " Liquidation Values and Debt Capacity: A Market Equilibrium Approach," Journal of Finance, American Finance Association, vol. 47(4), pages 1343-66, September.
  14. 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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  16. 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.
  17. repec:fth:starer:98-25 is not listed on IDEAS
  18. 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.
  19. repec:fth:starer:9825 is not listed on IDEAS
  20. Tuckman, Bruce & Vila, Jean-Luc, 1992. " Arbitrage with Holding Costs: A Utility-Based Approach," Journal of Finance, American Finance Association, vol. 47(4), pages 1283-302, September.
  21. 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.
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