Who Limits Arbitrage?

The cost of selling a security short is an equilibrium outcome of the demand for short positions and the willingness of long-term institutional investors to lend their securities to short sellers. We introduce an imperfectly competitive securities lending market into a model of securities traders with private information. Long-term institutional investors with greater liquidity risk tolerance are more willing to lend their securities, lowering the cost of taking short positions, which increases price informativeness in the spot trading market. We find empirical support for these predictions in the universe of corporate bond trades and life insurers' corporate bond loans.

Keywords: limits of arbitrage, securities lending, life insurers, corporate bonds, market

JEL Classification: G11, G22, G23

Suggested Citation: Suggested Citation

Foley-Fisher, Nathan and Narajabad, Borghan and Verani, Stephane, Who Limits Arbitrage? (July 1, 2020). Available at SSRN: https://ssrn.com/abstract=3361902 or http://dx.doi.org/10.2139/ssrn.3361902