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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 multiperiod 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. In our model, arbitrage activity benefits all investors because arbitrageurs supply liquidity to the market. However, arbitrageurs might fail to take a socially optimal level of risk, in the sense that a change in their positions can make all investors better off. We characterize conditions under which arbitrageurs take too much or too little risk.

Suggested Citation

  • Gromb, Denis & Vayanos, Dimitri, 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.
  • Handle: RePEc:ehl:lserod:448
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    JEL classification:

    • F3 - International Economics - - International Finance
    • G3 - Financial Economics - - Corporate Finance and Governance

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