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Rational Limits to Arbitrage


  • Jean-Pierre Zigrand



It is often argued that asset prices exhibit patterns incompatible with the behaviour of rational, optimizing agents. This paper proposes a rational framework which generates asset prices which appear irrational. This is accomplished by studying rational expectations equilibria in the presence of two realistic market frictions: immediacy risk (agents have to submit their demand functions before they know the equilibrium price) and asset-specific orders (investors have to submit one seperate demand for each asset, which may not be contingent upon the prices of the other assets). We study some of the properties of such equilibria, in particular the prevalence of arbitrage and of informational inefficiencies.

Suggested Citation

  • Jean-Pierre Zigrand, 2001. "Rational Limits to Arbitrage," FMG Discussion Papers dp392, Financial Markets Group.
  • Handle: RePEc:fmg:fmgdps:dp392

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    References listed on IDEAS

    1. Radner, Roy, 1979. "Rational Expectations Equilibrium: Generic Existence and the Information Revealed by Prices," Econometrica, Econometric Society, vol. 47(3), pages 655-678, May.
    2. Dow, James & Gorton, Gary, 1994. " Arbitrage Chains," Journal of Finance, American Finance Association, vol. 49(3), pages 819-849, July.
    3. Allen, Beth E, 1981. "Generic Existence of Completely Revealing Equilibria for Economies with Uncertainty when Prices Convey Information," Econometrica, Econometric Society, vol. 49(5), pages 1173-1199, September.
    4. Ausubel, Lawrence M., 1990. "Partially-revealing rational expectations equilibrium in a competitive economy," Journal of Economic Theory, Elsevier, vol. 50(1), pages 93-126, February.
    5. Heifetz, Aviad & Polemarchakis, Heracles M., 1998. "Partial Revelation with Rational Expectations," Journal of Economic Theory, Elsevier, vol. 80(1), pages 171-181, May.
    6. Albert S. Kyle, 1989. "Informed Speculation with Imperfect Competition," Review of Economic Studies, Oxford University Press, vol. 56(3), pages 317-355.
    7. Allen, Beth, 1985. "The existence of rational expectations equilibria in a large economy with noisy price observations," Journal of Mathematical Economics, Elsevier, vol. 14(1), pages 67-103, February.
    8. Jean-Pierre Zigrand, 1999. "Arbitrage and Endogenous Market Integration," FMG Discussion Papers dp319, Financial Markets Group.
    9. Craig W. Holden, 1995. "Index arbitrage as cross‐sectional market making," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 15(4), pages 423-455, June.
    10. Kreps, David M., 1977. "A note on "fulfilled expectations" equilibria," Journal of Economic Theory, Elsevier, vol. 14(1), pages 32-43, February.
    11. Jordan, James S. & Radner, Roy, 1982. "Rational expectations in microeconomic models: An overview," Journal of Economic Theory, Elsevier, vol. 26(2), pages 201-223, April.
    12. Allen, Beth, 1985. "The existence of fully rational expectations approximate equilibria with noisy price observations," Journal of Economic Theory, Elsevier, vol. 37(2), pages 213-253, December.
    13. Sanford J. Grossman, 1977. "The Existence of Futures Markets, Noisy Rational Expectations and Informational Externalities," Review of Economic Studies, Oxford University Press, vol. 44(3), pages 431-449.
    14. Klemperer, Paul D & Meyer, Margaret A, 1989. "Supply Function Equilibria in Oligopoly under Uncertainty," Econometrica, Econometric Society, vol. 57(6), pages 1243-1277, November.
    15. Diamond, Douglas W. & Verrecchia, Robert E., 1981. "Information aggregation in a noisy rational expectations economy," Journal of Financial Economics, Elsevier, vol. 9(3), pages 221-235, September.
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    Cited by:

    1. Danielsson, Jon & Taylor, Ashley & Zigrand, Jean-Pierre, 2005. "Highwaymen or heroes: Should hedge funds be regulated?: A survey," Journal of Financial Stability, Elsevier, vol. 1(4), pages 522-543, October.
    2. Zigrand, Jean-Pierre, 2004. "A general equilibrium analysis of strategic arbitrage," Journal of Mathematical Economics, Elsevier, vol. 40(8), pages 923-952, December.
    3. Danielsson, Jon & Taylor, Ashley & Zigrand, Jean-Pierre, 2004. "Highwaymen or heroes: should hedge funds be regulated?," LSE Research Online Documents on Economics 24782, London School of Economics and Political Science, LSE Library.

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