Limits of Arbitrage: The State of the Theory

35 Pages Posted: 17 Mar 2010

See all articles by Denis Gromb

Denis Gromb

HEC Paris

Dimitri Vayanos

London School of Economics; Center for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Multiple version iconThere are 4 versions of this paper

Date Written: March 2010

Abstract

We survey theoretical developments in the literature on the limits of arbitrage. This literature investigates how costs faced by arbitrageurs can prevent them from eliminating mispricings and providing liquidity to other investors. Research in this area is currently evolving into a broader agenda emphasizing the role of financial institutions and agency frictions for asset prices. This research has the potential to explain so-called "market anomalies" and inform welfare and policy debates about asset markets. We begin with examples of demand shocks that generate mispricings, arguing that they can stem from behavioral or from institutional considerations. We next survey, and nest within a simple model, the following costs faced by arbitrageurs: (i) risk, both fundamental and non-fundamental, (ii) short-selling costs, (iii) leverage and margin constraints, and (iv) constraints on equity capital. We finally discuss implications for welfare and policy, and suggest directions for future research.

Keywords: financial constraints, financial institutions, limits of arbitrage, liquidity, market anomalies, survey

JEL Classification: D6, D8, G1, G2

Suggested Citation

Gromb, Denis and Vayanos, Dimitri, Limits of Arbitrage: The State of the Theory (March 2010). CEPR Discussion Paper No. DP7738. Available at SSRN: https://ssrn.com/abstract=1573442

Denis Gromb (Contact Author)

HEC Paris

1 rue de la Liberation
Jouy-en-Josas Cedex, 78351
France

Dimitri Vayanos

London School of Economics ( email )

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London WC2A 2AE
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+44 (0)20 7955 6382 (Phone)
+44 (0)20 7955 7420 (Fax)

Center for Economic Policy Research (CEPR)

London
United States

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

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