The Macroeconomic Implications of Limited Arbitrage

41 Pages Posted: 17 Jan 2017 Last revised: 5 Jul 2019

See all articles by Ally Zhang

Ally Zhang

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

Date Written: July 3, 2019

Abstract

We develop a model to incorporate securitization into speculations and study the transmission channel between arbitrage crashes and recessions in the real economy. We show that the interaction between limited arbitrage and the business cycle works as a powerful transmission mechanism, where trivial shocks can spread, amplify and trigger simultaneous arbitrage failure and recessions. The securitization allows real-sector investments to have extra collateral value and thus helps boost the aggregate production. We solve the closed-form model and characterize multiple equilibria. Through regime shifts, we account for the nonlinearity of financial crises as well as the slow and limited post-crisis recovery.

Keywords: limits of arbitrage, financial crises, mispricing, regime shifts, multiple equilibria, collateral constraints, externality, slow recovery

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

Suggested Citation

Zhang, Quan, The Macroeconomic Implications of Limited Arbitrage (July 3, 2019). 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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