Asset Pricing with Arbitrage Activity

56 Pages Posted: 8 Nov 2013

See all articles by Julien Hugonnier

Julien Hugonnier

Swiss Federal Institute of Technology Lausanne - Ecole Polytechnique Fédérale de Lausanne; Swiss Finance Institute

Rodolfo Prieto


Date Written: October 2013


We study an economy populated by three groups of logarithmic agents: Constrained agents subject to a portfolio constraint that limits their risk-taking, unconstrained agents subject to a standard nonnegative wealth constraint, and arbitrageurs with access to uncollateralized credit. Such credit is valuable as it allows arbitrageurs to exploit the limited arbitrage opportunities that emerge endogenously in reaction to the portfolio imbalance generated by constrained agents. The model is solved in closed-form and we show that, in contrast to most equilibrium models with frictions and logarithmic agents, arbitrage activity has an impact on the price level and generates both excess volatility and the leverage effect. We show that these results are due to the fact that arbitrageurs lever up in good times and delever in bad times, and also investigate the effects of an unexpected tightening of the funding liquidity conditions of arbitrageurs.

Keywords: Limits of arbitrage; Rational bubbles; Wealth constraints; Excess volatility; Leverage effect

JEL Classification: D51, D52, G11, G12

Suggested Citation

Hugonnier, Julien and Prieto, Rodolfo, Asset Pricing with Arbitrage Activity (October 2013). Swiss Finance Institute Research Paper No. 13-57, Available at SSRN: or

Julien Hugonnier (Contact Author)

Swiss Federal Institute of Technology Lausanne - Ecole Polytechnique Fédérale de Lausanne ( email )

Quartier UNIL Dorigny
Lausanne, CH-1015

HOME PAGE: http://

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4

Rodolfo Prieto

INSEAD ( email )

Boulevard de Constance
77305 Fontainebleau Cedex

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