19 Pages Posted: 8 Jan 2009
Date Written: October 15, 2007
Economists often associate information efficiency of prices with allocative (Pareto) efficiency. When arbitrageurs connect segmented markets to correct a misallocation of risk, this assumption is sound. However, when opportunities for arbitrage or financial innovation arise from mispricings caused by the presence of confused investors or other distortions, such market-making is harmful. Rather than arbitrage facilitating the flow of risk to those who can most efficiently bear it, this harmful arbitrage allocates risk to those who least understand it. The beneficial effects of efficient pricing on real investment decision mitigate the harms caused by arbitrage, but also limits its benefits by providing substitute insurance. Even when arbitrage is not strictly harmful, it may be oversupplied, especially given that it typically employ some of the most talented workers.
Keywords: arbitrage, social welfare, behavioral finance, credit crisis
JEL Classification: D52, D61, D82, G18
Suggested Citation: Suggested Citation