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On the Role of Arbitrageurs in Rational Markets

Suleyman Basak
London Business School; Centre for Economic Policy Research (CEPR)

Benjamin Croitoru
McGill University - Faculty of Management

October 2005

EFA 2004 Maastricht Meetings Paper No. 2390; AFA 2004 San Diego Meetings

Abstract:
We investigate the role of "arbitrageurs," who exploit price discrepancies between redundant securities. Arbitrage opportunities arise endogenously in an economy populated by rational, heterogeneous investors facing investment restrictions. We show that an arbitrageur alleviates these restrictions and improves the transfer of risk amongst investors. When the arbitrageur behaves noncompetitively, taking into account the price impact of his trades, he optimally limits the size of his positions due to his decreasing marginal profits. When the arbitrageur is subject to margin requirements and is endowed with capital from outside investors, the size of his trades and capital are endogenously determined in equilibrium.

Keywords: arbitrage, asset pricing, margin requirements, noncompetitive markets, risk-sharing

JEL Classifications: C60, D50, D90, G11, G12

Working Paper Series

Date posted: December 04, 2003 ; Last revised: October 19, 2005

Suggested Citation

Croitoru, Benjamin and Basak, Suleyman, On the Role of Arbitrageurs in Rational Markets (October 2005). EFA 2004 Maastricht Meetings Paper No. 2390; AFA 2004 San Diego Meetings. Available at SSRN: http://ssrn.com/abstract=475483 or doi:10.2139/ssrn.475483

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Contact Information

Suleyman Basak (Contact Author) London Business School ( email ) Sussex Place Regent's Park London NW1 4SA NW1 4SA United Kingdom 44 (0)20 7000 8256 (Phone) 44 (0)20 7000 8201 (Fax) HOME PAGE: http://faculty.london.edu/sbasak/
Centre for Economic Policy Research (CEPR) 90-98 Goswell Road London EC1V 7RR United Kingdom
Benjamin Croitoru McGill University - Faculty of Management ( email ) 1001 Sherbrooke St. West Montreal, Quebec H3A1G5 H3A 2M1 Canada 514-398-3237 (Phone) 514-398-3876 (Fax)