Does Arbitrage Flatten Demand Curves for Stocks?
NYU Stern School of Business; National Bureau of Economic Research (NBER)
Paris School of Economics; New Economic School
The Journal of Business, Vol. 75, No. 4, October 2002
In the classic theory of Scholes (1972), 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.
JEL Classification: G1Accepted Paper Series
Date posted: April 24, 2001
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