Capital Market Equilibrium with Mispricing and Arbitrage Activity

Abstract:     
This paper develops a general equilibrium, continuous time model where portfolio constraints generate mispricing between redundant securities. Constrained consumption-portfolio optimization techniques are adapted to incorporate redundant, possibly mispriced, securities. We demonstrate the necessity of mispricing for equilibrium when agents are heterogeneous enough. The construction of a representative agent with stochastic weights allows us to characterize prices and allocations, given mispricing occurs, in a general setting. Under logarithmic preferences, we provide explicit conditions for mispricing and closed-form expressions for all economic quantities. Existence of an equilibrium when mispricing occurs with positive probability is verified in a specific case. We demonstrate how mispricing induces agents to engage in riskless arbitrage trades.

JEL Classification: C60, D52, D90, G12

working papers series