Financial Relationships and the Limits to Arbitrage

Abstract:     
We propose a new foundation for the limits to arbitrage based on financial relationships between arbitrageurs and banks. Financially constrained arbitrageurs may choose to seek additional financing from banks who can understand their strategies. However, a hold-up problem arises because banks cannot commit to provide capital and have the financial technology to profit from the strategies themselves. Weary of this, arbitrageurs will choose to stay constrained and limit their correction of mispricing unless banks have sufficient reputational capital. This form of limited arbitrage arises when mispricing is largest and becomes more substantial as the degree of competition between banks intensifies and arbitrageur wealth increases.

Keywords: Limits to arbitrage, inefficient markets, financial relationships

Working Paper Series