The Macroeconomics of Arbitrage Trading -- Dynamics and Multiple Equilibria with Arbitrage, Production and Collateral Constraints

50 Pages Posted: 17 Jan 2017 Last revised: 17 Aug 2018

See all articles by Ally Zhang

Ally Zhang

Department of Finance, Lancaster University Management School; Swiss Finance Institute

Date Written: August 14, 2018

Abstract

We develop a simple general equilibrium model to study the interactions between limits of arbitrage and aggregate economic activities within a conventional macroeconomic framework. Financially constrained arbitrageurs exploit price anomaly across segmented markets while collateralizing their arbitrage trades with capital investment in the production sector. We derive the model dynamics analytically to illustrate that mispricing arising from insufficient arbitrage activities helps boost the production by raising the marginal return of capital with collateral premium. However, limited arbitrage also renders the economy vulnerable to systemic risks. In addition, we analytically characterize the multiple equilibria to account for the nonlinear aspects of financial crises and the post-crisis recovery through regime shifts.

Keywords: limits of arbitrage, financial intermediary, segmented markets, financial crises, mispricing, regime shift, multiple equilibria, collateral constraints, externality

JEL Classification: D52, D58, E44, G01, G12

Suggested Citation

Zhang, Quan, The Macroeconomics of Arbitrage Trading -- Dynamics and Multiple Equilibria with Arbitrage, Production and Collateral Constraints (August 14, 2018). Swiss Finance Institute Research Paper No. 17-02. Available at SSRN: https://ssrn.com/abstract=2899866 or http://dx.doi.org/10.2139/ssrn.2899866

Quan Zhang (Contact Author)

Department of Finance, Lancaster University Management School ( email )

Economics Department,
LUMS,
Bailrigg Lancaster, LA1 4YX
United Kingdom
+441524592776 (Phone)

HOME PAGE: http://www.allyquanzhang.com/wordpress/

Swiss Finance Institute ( email )

Plattenstrasse 32
Zurich, ZH 8032
Switzerland

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